Is There a Global Shortage of Safe Assets?

David Beckworth has channeled Gary Gorton to write:

One of the key problems facing the world economy right now is a shortage of assets that investors would feel comfortable using as a store of value.  There is both a structural and cyclical dimension to this shortage of safe asset problem, with the latter being particularly important now given the recent spate of negative economic shocks to the global economy… 

Okay, so why does this safe asset shortage ultimately matter?  The first reason is that many of these safe assets serve as transaction assets and thus either back or act as a medium of exchange.  AAA-rated MBS or sovereigns have served as collateral for repurchase agreements, which Gary Gorton has shown were the equivalent of a deposit account for the shadow banking system.   The disappearance of safe assets therefore means the disappearance of money for the shadow banking system.  This creates an excess money demand problem for institutional investors and thus adversely affects nominal spending.  The shortage of safe assets can also indirectly cause an excess money demand problem at the retail level if the problems in the shadow banking system spill over into the economy and cause deleveraging by commercial banks and households.  

The logic here makes a lot of sense. Just as bank deposits serve in important ways as “money”; so other safe assets are used in a currency-like fashion in financial markets. Loss of faith in these assets can drive market exchange in financial markets into turmoil — as Gary Gorton argues happened with previously AAA-rated mortgage-backed securities and repurchase agreements.

I’ve grown skeptical of this line of thinking, however, after reading Jeffrey Friedman’s (and Vladimir Kraus') excellent book, Engineering a Financial Crisis. Friedman focuses on the distortions in bank actions caused by Basel financial regulation, and I think his argument is relevant in this case. There are three reasons here I can think of that the “global safe asset shortgage” might be overblown:

1. AAA-rated assets aren’t the only safe ones. Beckworth tallies up the number of AAA-rated assets worldwide, and find that their aggregate amount — including Treasuries, etc. — Is actually decreasing, due to downgrades of various bonds.  

But buying a AAA-rated asset isn’t the only way to ensure you own a risk-free security Alternatively, one could buy credit default protection on a riskier asset. Purchasing a risky asset and credit protection is economically equivalent to purchasing a risk-free asset; and credit default swaps are priced accordingly. Practically speaking, this is what banks did in order to hedge their holdings of risky European debt -- they bought credit protection to get out of credit risk. Further ratings drops don’t effect the immediate economic future of a bank whose holdings of risky debt are fully insured - short of the CDS counterparty going bankrupt, or Europeans conspiring to negate CDS contracts as they recently did.     

And the global supply of CDS is enormous. There is something like $43 trillion in sum notional value of credit default swaps. Now, netting out all of the various contracts and figuring out how much actual additional risk protection the CDS market provides is tricky. But certainly it seems this is a massive source of safe assets for any risk averse entity that wants them. 

Now, it may be the case that you actually need AAA-rated assets to use as a medium of exchange; so CDS contracts don’t help with that precise problem. But certainly it would seem that the presence of a massive asset class economically equivalent to AAA-rated assets should change our judgement of whether or not safe assets are scarce. If nothing else, we might expect that “true” AAA rated assets may start to be used exclusively for repos; while banks wishing to hold safe assets would switch to holding risky assets + credit insurance. 

2. Repos blew up due to bankruptcy laws. Why would you try to fund a shadow bank with repurchase agreements? In Beckworth’s piece, this is treated as a given — we just happen to have  a sophisticated banking system that relies on this particular form of short-term liability. 

However, as Mike Konczal and others have mentioned http://rortybomb.wordpress.com/2010/05/06/an-interview-about-the-end-user-exemption-with-stephen-lubben/: the repo market really took off after the 2005 bankruptcy law reform. That law granted repos and other derivatives prioritized status in the event of bankruptcy; and so dramatically raised the incentives to finance a shadow bank using these sorts of short-term debts. 

Yet there’s no reason in general to run a financial system on this type of risky short-term debt. No lawe decrees that short-term collateralized lending needs to be such a large part of a sophisticated banking system that sits apart from the normal loan-deposit world. This is as much a product of specific rules and regulations that encourage re-writing contracts in the form of derivatives; as it is of a general preference for “safe” assets.

3. It's all Basel's Fault Anyway. The final thing I think this narrative gets wrong is the motivation for why people want safe assets. The focus from Beckworth and Gorton is on AAA-rated assets used in their capacity as money. However, banks and other financial institutions also hold enormous amounts of AAA-rated securities that they store on their balance sheets. This fits in, say, with how we typically think of safe assets — as non-risky assets that some financial intermediary wants to hold on their balance sheet for some amount of time, not just as collateral to buy something else. There isn't a hard line between those two uses, but it certainly seems that there's a large pile of AAA-rated securities that aren't just functioning in the capacity of money. 

Here Jeffrey Friedman’s book comes in useful. Friedman notes the impact of Basel-I and Basel-II reforms on the capital consequences of asset holdings. Particularly after Basel-II prioritized the role of ratings agencies, banks started to face dramatically different consequences from holding “safe” and “risky” assets — as determined by credit agencies.

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response. 

The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo. 

For instance, here is a recent news story from Australia, a country that (by virtue of low government debt) has relatively few safe assets. Liquidity coverage ratios required for Basel-III leave Australia in a problem, due to the local shortage of safe assets. The Reserve Bank of Australia describes in detail their response:

The issue in Australia is that there is a marked shortage of high quality liquid assets that are outside the banking sector (that is, not liabilities of the banks). As a result of prudent fiscal policy over a large run of years at both the Commonwealth and state level, the stock of Commonwealth and state government debt is low. At the moment, the gross stock of Commonwealth debt on issue amounts to around 15 per cent of GDP, state government debt (semis) is around 12 per cent of GDP.[¹] These amounts fall well short of the liquidity needs of the banking system. To give you some sense of the magnitudes, the banking system in Australia is around 185 per cent of nominal GDP. If we assume that banks’ liquidity needs under the liquidity coverage ratio (LCR) may be in the order of 20 per cent of their balance sheet, then they need to hold liquid assets of nearly 40 per cent of GDP.

In addition to government debt, the Basel standard also includes balances at the central bank in its definition of high-quality liquid assets (level 1 assets in the Basel terminology). That is, the banks’ exchange settlement (ES) balances at the RBA are also a liquid asset. Hence, one possible solution to the shortage of level 1 assets would be for banks to significantly increase the size of their ES balances to meet their liquidity needs. While this is possible, it would mean that the RBA’s balance sheet would increase considerably. The RBA would have to determine what assets it would be willing to hold against the increase in its liabilities, and would be confronted by the same problem of the shortage of assets in Australia outside the banking system. Similarly, the government could increase its debt issuance substantially with the sole purpose of providing a liquid asset for the banking system to hold. Again, it would be confronted with the problem of which assets to buy with the proceeds of its increased debt issuance. Moreover, it would be a perverse outcome for the liquidity standard to be dictating a government’s debt strategy. 

However, the Basel Committee acknowledges that there are jurisdictions such as Australia where there is a clear shortage of high quality liquid assets. In such circumstances, the liquidity standard allows for a committed liquidity facility to be provided by the central bank against eligible collateral to enable banks to meet the LCR.

It’s clear reading this description that the shortage of safe assets refers only to a shortage of assets declared safe by the Basel committee. Australia, absent international banking regulations, had no problem running a safe banking system. Yet the new banking regulations left Australia’s banks as exposed. The response, bizarrely enough, is a central bank that is acting as a shadow bank — adopting maturity mismatch in order to supply assets to banks that Basel will count as safe for the purposes of regulation. 

From my perspective, it seems that this decade-long obsession with safe assets is due in large part to financial institutions facing systematically different incentives. They went with repos because those were guaranteed even in bankruptcy. Financial institutions loaded up on AAA-rated mortgage-backed securities and sovereign paper — not just on the medium of exchange side, but also on their long-term balance sheet — because Basel wrongly declared these to be “risk-free.” Subsequent downgrades led to financial carnage; but the root of the problem lay in the assumption that credit ratings could substitute for prudential management by banks themselves. The global “shortgage” or demand for safe assets was really a demand for ways to conduct regulatory arbitrage; and the growth in structured products (as well as sovereign European debt) was a supply-side response to that demand. 

The Federal Reserve and Stagnating Wages

I've written before about stagnating household wages in the US. My sense is that while wages have stagnated in recent decades, the growth living standards have not, and issues in the provision of government goods, education, and healthcare have a lot to do with why growth in income isn't keeping up with growth in real consumption spending.

Mike Konczal has proposed one different explanation centered on the recent behavior of the Federal Reserve:

Here’s a question I’ve been trying to find research on lately – how much is the post-Volcker era of monetary policy responsible for stagnating wages and high-end inequality? I’m pretty familiar with the stories and arguments surrounding these two topics, and the Federal Reserve never shows up. It’s almost like taking an American phone charger overseas; there’s no place for monetary policy to “plug-in” the current research and arguments, from technology to superstars to policy to everything else, on wages/inequality.  Which is weird, since when you read transcripts of their FOMC meetings, released years after the time when they were recorded, the board members are obsessed with wages.   We have a sense of the Greenspan Put for the financial sector, but what’s the Greenspan option-metaphor for workers?

I was pretty skeptical of this idea when I first heard this. By what mechanism does the Fed targeting wage growth instead of CPI growth actually manifest itself into stagnating wages? Still, I wasn't able to think of a more effective argument against this on the spot. Nick Rowe, in a recent set of posts on related issues, argues against this idea much better:

1. Consider this policy proposal:
"I think the Bank of Canada should switch from targeting CPI inflation to targeting wage inflation. I'm not hung up on the exact rate of wage inflation the Bank should target. My guess is that something like 2.5% wage inflation would be roughly right, and would give us roughly the same 2% CPI inflation in future. But if you want to argue for a higher or lower target rate of wage inflation, I don't really care a lot. So if wages start to increase faster/slower than 2.5%, the Bank of Canada should raise/lower interest rates, reducing/increasing demand for goods and labour, which would put downward/upward pressure on wage increases."
(BTW, I'm not actually proposing that, though it's not a bad policy, and is worth considering. And the merits or demerits of that proposal is not the point of this post.)
2. Reactions.
2a Macroeconomists. Any New Keynesian (for example) macroeconomist would react to the above policy proposal like this:
"Ho hum. Nothing new here. Nick hasn't even given us any reasons why targeting wage inflation would be better than targeting CPI inflation. I could build a model where one would be better in some cases, and the other would be better in other cases. It all depends on: whether wages are stickier than prices; on the source of the shocks; the exact specification of the model and its parameter values; and stuff like that. It might matter in the short run, but won't matter much if at all in the long run (unless better performance in the face of short run shocks leads to a higher growth rate).

The post goes on to discuss various other issues. But I think this snippet here captures the gist of the critique. Even if the Fed were somehow actually targeting wage inflation; there is a whole set of models out there that imply that the impact on actual real wages is a lot more indeterminate than you might think.

Of course, one could probably develop a model in which wage stagnation was the logical outcome of targeting nominal wages; or one could reject the New Keynesian paradigm entirely (in which case one should probably stop reading Paul Krugman as well). It was just nice for me to run into some critique (however ill-defined) against the idea that stagnating wages are due to the Fed's policy target.

Delevering

Matt Rognile takes aim at people claiming “deleveraging” is an important reason behind the prolonged downturn:

In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

Elsewhere, he argues that many households, despite the fall in home prices, do have substantial assets. 

The deleverage hypothesis argues that aggregate GDP will remain weak as long as household consumption is held back through the presence of debts. Rognile retorts that the balance of savings and investment is adjusted through interest rates; and that the changes in net assets can’t really support economically meaningful drops in consumption corresponding to the output declines we’ve seen. 

I think there’s a lot true here. David Beckworth has also made  a number of powerful arguments connecting deleverage to monetary policy:

For every household debtor deleveraging there is a creditor getting more payments.  Yes, household debtors have cut back on spending, but so have creditors.  The creditors could in principle provide an increase in spending to offset the decrease in  debtors' spending.  They aren't and thus the economic recovery is stalled. In other words, the problem is as much or more about the build up of liquid assets by creditors as it is the deleveraging of debtors… 

The key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.

I think Beckworth actually makes a more powerful case than Rognile. Even if households had good reason to save more; it’s not obvious that lower household consumption would necessarily lead to lower aggregate output, so long as the banks and creditors receiving those payments went out and lent the money. Then the usual money multiplier arguments would ensure a rapid circulation of credit throughout the economy, raising output. After all, we typically think that higher saving and investment is a good thing for economies; as opposed to thinking that money saved is wasted. 

There are two reasons that isn’t going on, relating to an excess demand for money: households desperately want to hold more liquid assets and hold fewer debt commitments; while creditors also are inclined to hold liquid assets rather than lend those out. Logically, the only way that a flow of money from households to creditors can have any aggregate effects is if agents in an economy simultaneously have an excess demand for money not met by the central bank. 

When you think about it this way, it becomes easier to diagram how to think about deleveraging. There are basically three categories I see:

1) People who think that deleveraging is real, and no amount of monetary stimulus will help. 

These are people like Richard Koo. Their argument goes that the presence of excess debt is the key constraint holding back economic growth. No amount of monetary stimulus will fundamentally change the asset position of households, and so there’s no way it will alter consumption or output (or, at least, not to the degree that is necessary). Raghuram Rajan may believe something like this, as best as I can tell. The MMT folks are probably best placed here as well. 

As Beckworth and Rognile point out above, this view doesn’t make sense given the conventional understanding of how monetary policy ought to operate. If we desire greater spending from households or creditors; we can always make that happen by flooding the system with money. 

2) People who think that deleveraging is real, monetary stimulus could help, but the Fed won’t deliver enough. 

These are people like Paul Krugman. As Rognile points out — Krugman is careful to note how deleverage is only an issue if you’re in a liquidity trap, but that nuance tends to be lost among many other commentators. Elsewhere, he has argued that fiscal stimulus is only worthwhile as long as interest rates are zero — at other times, he often takes for granted that monetary policy ought to handle the brunt of aggregate demand management (or at least he did in the '90s). 

In that sense, Krugman actually agrees with Scott Sumner on more issues of intellectual substance than, say, with Keynes. It’s just that Krugman believes that in this particular instance, we happen to be in some kind of liquidity trap in which monetary policy won’t be sufficient to tackle the headwinds of a deleverage cycle. 

3) Then; there are people who believe that deleveraging may be a concern; but monetary policy (even with a zero-rate bound) ought to handle everything.

Here are the market monetarists like Scott Sumner and David Beckworth, as well as Matt Rognile. The belief is not only that monetary policy can fix any conceivable deleverage shock; but that the Fed could do so tomorrow given the set of tools they have; involving perhaps the adoption of a price level, getting more QE, imposing interest on reserves, or offering guidance on the future path of interest rates. 

Many people on sides 1 and 2 agree on issues; but there’s a fundamental conceptual difference there. Suppose, as Mike Konczal likes to imagine, that we wake up tomorrow and find that interest rates are actually 2%, rather than at 0% for the short-term Treasury rate. What should we do? Some people (like perhaps Koo?) would argue that changing that rate wouldn’t do very much. But people like Krugman would argue that, if we were in an environment in which conventional monetary policy could operate, then that’s basically the only policy channel we should use to get output back.

The only difference between sides 2 and 3 is whether or not the liquidity trap proves binding. This seems like a fairly trivial issue; but it determines entirely whether or not you think that we should adopt fiscal stimulus, or simply Ben Bernanke with a more aggressive Fed Chair. 

Where’s the Evidence for Deleveraging?

Some of the best evidence in favor of a deleverage model comes from cross-sectional cuts comparing debt to economic outcomes. For instance, Mian and Sufi find that high household debt areas have lower employment than low household debt areas:

One way to think about this is in some kind of Bernanke-Gertler approach in which households use their homes as collateral. When home prices were increasing, households used their houses like credit cards and extracted some of the equity. Now, when debt levels are high, the same households are cutting back; and employment is suffering. (Philippon and Midrigan have a paper highlighting this channel, though they also emphasize the role of monetary policy to counteract that)

The issue with this type of finding is ensuring identification. It seems intuitive that the parts of the country which participated in the housing boom most heavily would have some of the worst outcomes right now. But what’s the channel by which that operates? If it’s the debt, than we have some possible fixes — do some mass refinancing or mass principal writedowns (which may be good ideas themselves for other reasons).

But I don’t think it’s obvious that demand-side issues are at work in explaining the poor economic outcomes of post-real estate bust areas. Erik Hurst instead points to supply-side effects coming from the structural challenges in re-orienting a local economy away from real estate investment. He points to the following graph:

Here, he shows that the change in unemployment rate mirrors closely the change in the composition of output away from real estate-financial sectors. You have laid off construction workers, for instance, who find it difficult to retrain and find new jobs. Lowering outstanding mortgage principal won’t necessarily help retrain a laid-off-construction worker as a nurse. In fact, lowering the principal on a mortgage might induce that laid-off-worker to remain in a housing bust area instead of moving to North Dakota, where the unemployment rate might as well be zero; raising unemployment (this is basically what Lee Ohanian and Kyle Herkenhoff argue). The economy may just be in for a sustained period of slowdown as individual agents attempt to find a new sustainable equilibrium. 

I’m not wed to either the demand/debt or construction/supply approach — I just want to point out it’s not obvious to think about the role of debt, or even the relative ratio of supply side and demand side issues in explaining a weak economy. No one has credible causal estimates of how lowering debt burdens would help household or economy-wide welfare. Household and bank-centered approaches are very appealing in trying to explain why the recovery has been as weak as it is, but I don’t think all of the stories hang together. 

To Fix Bank of America: Rules not Discretion

Despite Warren Buffet's interventions, The troubles at Bank of America seem large. Over concerns of rising credit losses and lawsuit risk, the company’s stock has plummeted, while the price of credit default swaps to protect against default have risen.

Henry Blodget, at Business Insider, offers a plan to fix Bank of America:

First, Treasury Secretary Tim Geithner needs to set a "trigger price" for Bank of America stock. If Bank of America stock falls through this trigger price, he will then automatically put this plan into action…

·  Write down the value of Bank of America's assets by whatever it takes to make the balance sheet bombproof—focusing on second mortgages, commercial real-estate, European obligations, goodwill, and other "assets" that the market is skeptical about.

·  "Haircut" the unsecured creditors by whatever amount is necessary to close the gap between the asset writedown and the equity (BOFA currently has $222 billion of equity, so there's a lot to work with).

·  Inject $300 billion (or some multiple of the asset write-off) of fresh capital into the bank in the form of preferred and common stock—enough to make the bank extremely well-capitalized.

His prescription has much in common with several bank resolution strategies like  speed bankruptcy and a new bankruptcy chapter code. The common thread through these solutions is a reliance on a rules-based system for handling bank liabilities that would place the bulk of the burden on the holders of junior liabilities like equity and junior debt. These would be written off or written down in order to facilitate an orderly recapitalization under new management.

Of course, it remains to be seen what sort of credit losses Bank of America will ultimately bear. It may well the case that the company will manage without any writedowns. However, given the importance that Bank of America has on the larger economy, it’s essential to have in place a viable back up option.

Unfortunately, it seems unlikely, however, that Geithner and colleagues will actually follow the rules-based back up outlined above. Instead, if Bank of America requires a bailout, it will happen in a similar manner to the bailouts during the financial crisis — which were ad hoc and driven by regulatory discretion.

New revelations from the Fed reveal the extensive nature of those bailouts. In response to inquiries from Bloomberg news, the Fed has revealed the existence of loans offered to major financial institutions. These loans may be defended on the grounds that such lending fits with the Fed’s mandate as a central bank, and were essential to allowing  the financial system to weather the panic. However, the lack of transparency that surrounded their disbursement and the quality of the assets used as collateral is certainly troubling.

This new discovery helps make sense of a research finding by Daron Acemoglu, Simon Johnson, and colleagues. In a paper, this group found that Geithner’s appointment was associated with stock gains among companies with close ties to Geithner. These gains were not present among financial firms generally — suggesting that connections, rather than Geithner’s performance as Treasury Secretary, drove these firms profits. Interestingly, this same group of companies suffered as Geithner’s tax problems led to lengthy confirmation battle.

The overall pattern in the last several years has brought new waves of crony capitalism to the foreground. Firms have received loans and bailouts in line with personal connections, and have seen their share values fluctuate in proportion with the career prospects of individual bureaucrats. Dodd-Frank enshrines this discretion-based approach into law, and does not auger well for the creation of a functioning financial system. Instead, we need a financial system based on rules. Bank of America could be a good place to start depending how the market value of its liabilities and equity hold up over the coming weeks.

Teaching Practical Math and English

From the New York Times,

Today, American high schools offer a sequence of algebra, geometry, more algebra, pre-calculus and calculus (or a “reform” version in which these topics are interwoven). This has been codified by the Common Core State Standards, recently adopted by more than 40 states. This highly abstract curriculum is simply not the best way to prepare a vast majority of high school students for life...

Imagine replacing the sequence of algebra, geometry and calculus with a sequence of finance, data and basic engineering. In the finance course, students would learn the exponential function, use formulas in spreadsheets and study the budgets of people, companies and governments. In the data course, students would gather their own data sets and learn how, in fields as diverse as sports and medicine, larger samples give better estimates of averages. In the basic engineering course, students would learn the workings of engines, sound waves, TV signals and computers. Science and math were originally discovered together, and they are best learned together now.

This sounds very right to me. The article goes on to note the defenders of the traditional system, who argue that the current progression both prepares one for higher learning in mathematics, while providing certain abstract skills everyone needs.

The same was once said about Latin, as the article notes. Once upon a time, people thought that teaching Latin would have those spillovers as well. We've largely abandoned that notion in favor of teaching relevant languages in the classroom, but have kept these ideas in math.

But that's absurd. The current math curriculum is really only well geared to the fraction of the population that anticipates learning much more math. It completely turns off virtually everyone else, to the point that you have millions of people who think of themselves as "not math people," or minimally capable of grappling with essential quantitative skills. An alternate method would focus on street learning math style still that focus on a quantitative fluency for the tasks that typically find themselves facing. Understanding concrete examples in any case is the best way to built up an abstract understanding of the underlying rules, so will help the more math focused folks as well.

This is a huge problem in English too. The dominant way of teaching English rests on the belief that having students read works of literature and write literary analysis in a certain stylistic format somehow imparts knowledge of the English language. This is nuts. It ties together three skills -- reading novels, writing literary essays, and writing skills in general -- that are utterly different. What frequently happens is that you end up with students who can't navigate a complex novel or can't be bothered to figure out how to analyze a novel. So they wind up making their essay as complicated as possible to cover their ignorance. It is difficult to imagine a worse way to teach writing -- yet that's what we do despite the importance of verbal skills in the world.

In both fields there is an unnecessary reliance on Collegiate models of learning. High School math took after the sorts of quantitative skills in demand ~1900. High School English was shaped by the fact that College English departments, shaped by the flourishing of the German Research Institute model, specialized in "research" into works of literature. Whatever the merits of the underlying collegiate forms of education -- they are completely unsuited for teaching the mass of students basic quantitative and verbal skills.

Are Capital Markets Inherently Risky?

A new NBER paper by Michael Bordo, Angela Redish, and Hugh Rockoff look further into the causes of the superior performance of the Canadian Banking system:

The financial crisis of 2008 engulfed the banking system of the United States and many large European countries. Canada was a notable exception. In this paper we argue that the structure of financial systems is path dependent. The relative stability of the Canadian banks in the recent crisis compared to the United States in our view reflected the original institutional foundations laid in place in the early 19th century in the two countries. The Canadian concentrated banking system that had evolved by the end of the twentieth century had absorbed the key sources of systemic risk—the mortgage market and investment banking—and was tightly regulated by one overarching regulator. In contrast the relatively weak, fragmented, and crisis prone U.S. banking system that had evolved since the early nineteenth century, led to the rise of securities markets, investment banks and money market mutual funds (the shadow banking system) combined with multiple competing regulatory authorities. The consequence was that the systemic risk that led to the crisis of 2008 was not contained.

The superior performance of the Canadian banking system relative to the American one is a well-known fact in the banking literature. The decision by various populists and other forces to regulate American banking in a poor manner remains one of the single largest unforced errors in American economy history. Branch restrictions and other regulations led to a large fragmentation in the American banking sector, while Canadian banks were relatively more centralized. This meant that American banks were strongly undercapitalized and unable to deal with localized geographic agricultural shocks -- leading to chronic bank runs.

Canada avoided that. Even in the Great Depression, they largely avoided bank failure. Nor did they have deposit insurance until the 1960s. So it's not that the maturity transformation that banks do is inherently risky; or that financial systems are inherently prone to collapse. Instead, Canada just opted for a more stable, nationally centralized system that performed much better historically.

This paper adds to that knowledge by pointing out another key factor extending Canada's banking performance - the role of capital markets. American banks compensated for their geographical fragmentation by creating liquid capital markets on which to trade debt and other contracts.

The authors argue that this led to something of an inbuilt American national bias to rely on capital markets -- culminating recently with structured products like mortgage-backed securities. In Canada, comparable lending is still handled by banks extending loans to individuals. "Shadow banks" like Investment Banks have always been around in the US underwriting commercial paper or other offerings. These markets frequently failed during crises.

Interestingly, this difference also pops up in Japan, which I discussed here. The old Japanese school of Finance relied extensively on bank finance through the 80s. At that point, there was a large deregulatory shift in favor of capital markets, and also a financial crisis. That evidence isn't necessarily causal, but it is perhaps another reason to think that banking-oriented finance, as opposed to capital market-oriented finance, may have some advantages.

Female Labor Force Participation

Keith Chen and Judith Chevalier have a provocative paper on value of education to women:

We examine whether investing in becoming a physician is a positive net present value project for women who do so. We sidestep some selection issues associated with measuring the returns to education by comparing physicians to physician assistants, a similar profession with lower wages but much lower up front training costs. We find that the median female (but not male) primary-care physician would have been financially better off becoming a physician assistant in a primary-care field. This is partially due to a gender wage gap in medicine. However, our result is mostly driven by the fact that the median female physician simply doesn’t work enough hours to amortize her up-front investment in medical school. In contrast, male physicians work substantially more hours on average and the median male physician easily works enough hours to amortize his up-front investment. [emphasis added]

Once you account for the fact that women will generally spend less time in the workforce than men due to time spent childrearing, all sorts of puzzles come up. For instance — how is is that women now outnumber men in a variety of education outcome measures — such as graduating College — and are at parity with men in others — like Medical School attendance? Again, from Chen and Chavalier, we have that women’s lesser time in the workforce lowers the financial return to education -- to the point that med school seems a bad deal in financial terms on average for women.

It would seem likely that non-monetary returns play a large role. What is the relative premium that higher education brings men and women in the marriage market? In the past, higher education was if anything a liability for women’s marriage prospects. This seems less likely to be the case today. As Betsey Stevenson and Justin Wolfers have argued, marriage has gone from an institution encouraging complementarity in production to one of complementarity in consumption. This has encouraged levels of similarity between men and women along a number of different criteria in marriage.

That generates a number of positive spillovers from education for women, which are especially stark when considering the number of co-movements in social and economic trends over the years. For instance, women’s education is hugely predictive of future children’s success — in several studies, I believe, more important than the father’s education. College-educated and above households are substantially less likely to divorce or face other negative events than even high school-educated households — and that divergence is growing. High school-educated families increasingly resemble high school dropouts rather than College educated families. Divergences in job markets — in which College-educated jobs receive high and growing premiums, while jobs requiring a high school degree see stagnating incomes — encourage these trends.

So while Chen and Chevalier phrase their paper through the question, “Are women over-educating themselves?” I’d instead look at the empirical evidence that people are pursuing more education, and then think about what sort of incentives drive them to do that. The financial incentives are only a part of the picture. The non-financial incentives — marriage on average with a more stable, higher educated person, kids that will be better off as well, general transformations of life views — may be substantial.

There are all sorts of other social consequences resulting from a lower female workforce rate. For instance, Social Security and pension plans are typically gender-neutral in the sense that they require equal savings per dollar earned from men and women. This may make sense for families that do not anticipate divorce, in which total earnings are pooled and split to finance joint consumption. It doesn’t necessarily make sense for divorced families or single women. Given that women can also expect a greater life expectancy, the average women can anticipate lower savings to finance a longer retirement period. That doesn’t seem right. Women should probably be saving at far higher rates than men.

This also means that it doesn’t make too much sense to put men and women in a lab, observe that women take fewer risks than women, and then conclude that we need to put women in charge of banks because they're safer people. Laboratory experiments on men and women may reflect nature/nurture effects on fundamental risk preferences. But as long as men and women specialize differently in child rearing/time in the workforce/occupational structure; there’s no good reason to expect them to have identical risk preferences. In fact it would be nonsense to expect them to have identical risk preferences — yet that’s what pension plans do.

You also have the usual taxation questions. Marginal tax rates carry far higher deadweight losses on women than men, because women are more often on the margin between working or not. Progressive taxation produces additional burdens, as the wives of high-earning men can expect to keep much less of their earned income, and so more often choose to opt-out of the workforce entirely. The obvious solution would be to handle child subsidies in the form of reducing the entire marginal tax rate schedule for families with children; and tax households as two single individuals. If feminists got together with the tea party to make this happen, it would probably do more to encourage female labor force participation than any other act of public policy in fifty years. India already has a different tax rate system for men and women, so don't tell me this is impossible to think about.

There are also thorny issues related to admissions policy — as raised for instance by Posner on his blog. If Universities are aiming to maximize the success and income of future graduates to raise their own prestige; they will not be indifferent to the amount they want their graduates to work, and they will not be indifferent in choosing between two applicants, one of which plans on working much less in the future than another. Taxpayers, in general, will also not be indifferent between subsidizing the education of two people, one of whom plans on spending much less time in the job market than another (though that taxpayer might also be concerned about the human capital of others children as well). This presents obvious issues that I’ll leave to Posner to discuss.

There’s also a medicine-specific issue relating to this study. The authors mention that women represent 24% of first year medical students in 1976, but 48% in 2006. What does that imply in terms of the labor supply of doctor? The authors write:

Specifically, the median male doctor in our data has accumulated 37,594 hours of experience by 15 years post-residency, while the female doctor does not achieve that number of cumulative hours until year 19.

Roughly, that suggests that female doctor labor supply is 75% that of male doctors. The cumulative impact of achieving gender parity in medical school has reduced doctor supply by something like 6% since 1976 — or roughly 12-13% since women began attending medical schools in any numbers. That estimate could be higher if women also tend to retire earlier than men. And it doesn’t take into account any “learning-by-doing” effects that might leave women less qualified than an otherwise identical man due to their less time in the workforce.

In most other fields, this wouldn’t be a huge issue. The fact that women work less than men would be balanced by the fact that they’re entering the workforce to begin with.

But medicine is different given that the AMA operates a cartel regulating tightly the number of medical school seats. The role of this cartel in limiting the supply of doctors and raising medical costs is strongly under-covered.

And has the AMA thought about this issue? One imagines that they have not. If we assume that the AMA was optimizing medical school seats so as to maximize monopoly profits but didn’t consider the impact of greater female participation on overall doctor labor supply — than we have too few doctors relative to the optimal number doctors a monopoly would prefer. I can’t think of another case where a monopoly has irrationally undersupplied its product. Ironically, alleviating gender inequality in medical school admissions may have inadvertently raised income inequality, assuming I’m right in thinking that medical school slots are indeed fixed in this manner, given that the resulting lower supply of doctors surely raised medical costs on everyone, hurting proportionally more the poor.

To clarify — I’m not taking any stances on the desirability of greater female employment, or the labor decisions within households, or anything like that. One can draw many conclusions from this depending on ideological proclivities. For instance, one could say that the real problem is that men spend too much time in the workforce, and should spend equal time in home production. Or the real problem might be the cartel powers of the AMA. But certainly this is a real issue deserving greater attention.

The Texas Non-Bubble

Mike Konczal serves up some interesting graphs on the Texas economy. One important element he flags relates to jobs and the debt burden. Texas managed to go through the past decade with no housing bubble, and a limited increase in housing-related debt. This served the state a great deal in avoiding foreclosure and a subsequent “balance sheet” recession driven by households aiming for deleverage. Mike offers this commentary on how Texas did that:

Fisher states that a free regulatory environment is causing this growth, but the rather strong regulations on the mortgage market and growth in the housing stock are more likely the factors in preventing the build-up of housing debt that in turn isn’t holding back the economy. There are strong regulations on the housing market, especially in terms of housing equity loans that in turn make it harder to bid up values.

Well, why did Texas avoid a bubble? Mike flags consumer regulation. But I’d also point to lax local zoning and land use regulations.

The chief restriction on home equity loans in Texas is that they cannot exceed 80% of the market value of the home — essentially requiring all borrowers to have some sort of equity. Cash out refinances were restricted in the same manner. Requiring that homeowners place a sufficient amount as a downpayment, and restricting people from using equity gains as collateral to acquire new debt, substantially reduced speculation and cash outs.

But it’s something of an open question as to how much this reduced price fluctuation. Certainly, requiring sizable downpayments lowered the plausible group of buyers in a given property. However, the restriction on refinancing was probably a factor reducing leverage more than increasing price. Ie, it prevented existing homeowners from doubling down on home prices by acquiring more debt. Certainly, the option to extract future equity may have enticed buyers in other states. But limiting future equity extraction may or may not have been a small factor in actually inducing higher prices.

By contrast, there are good theoretical reasons to focus on housing restrictions. Paul Krugman argued all the way back in 2005 that house price appreciation seemed to be much higher in areas where geographic and zoning restrictions lowered the available supply of housing. Since then, Ed Glaeser and co-authors have written a paper arguing that price increases in housing were driven most strongly in areas where housing supply was relatively fixed.

This makes a lot of sense from a demand-supply framework. Where supply is flexible; builders respond to greater demand for housing by building more houses, so prices remain flat. Where supply is inflexible, increases in housing demand largely translate into increases in prices, not increases in the number of houses built. Even if the increase in housing demand comes from speculators who place little money down and expect to extract future equity from their houses; as long as builders can keep building this increase in demand will not translate into an increase in prices. You need both an increase in demand, as well as inflexible supply to generate an increase in housing prices.

The national data backs this idea up well enough, but there are two big stumbling blocks: basically Las Vegas and Phoenix. The housing market in these areas saw huge price increases, but the thinking is that land policy should have been fairly flexible here. If you look at both markets specifically though, the real problem may also have been inflexible housing supply:

In Nevada, something like 85% of all land is federally owned, including a lot of the land in the neighborhood of Las Vegas, and overseen by the Bureau of Land Management. A local journalist at the Nevada News & Views, Mike Chamberlain, has repeatedly emphasized the role of government ownership of land in building up the bubble. A federal law in 1998 split land sale proceeds with local governments, which gave local authorities strong incentives to try to bid up land sales. As this Economist article mentioned, other local housing participants in 2005 thought the government was far too stingy in releasing land at a suitable pace. At the very least, there are good reasons to think that not all of the land outside Las Vegas was free for development.

Phoenix is also wrongly classified as freely developable state. Rather, beginning in 1998, the state opted for a “growth management” policy limiting land use. Similar to Las Vegas, land outside of Phoenix land was held by the government, which limited sales to maximize revenues. This link from Demographia (honestly not sure how I ran across this, so perhaps take with a grain of salt) argues in Maricopa county, home to Phoenix, agricultural land was selling for a fraction of development land. The problem wasn’t a land shortage per se, so much as a segmented real estate market in which agricultural land was not easily convertible into housing. Wendell Cox at New Geography argues:

Building is largely impossible on the "abundance of land" surrounding Las Vegas and Phoenix. Las Vegas and Phoenix have virtual urban growth boundaries, formed by encircling federal and state lands. These are fairly tight boundaries, especially in view of the huge growth these areas have experienced. There are programs to auction off some of this land to developers and the price escalation during the bubble in the two metropolitan areas shows how a scarcity of land from government ownership produces the same higher prices as an urban growth boundary...

In Las Vegas, house prices escalated approximately 85% relative to incomes between 2002 and 2006. Coincidentally, over the same period, federal government land auctions prices for urban fringe land rose from a modest $50,000 per acre in 2001-2, to $229,000 in 2003-4 and $284,000 at the peak of the housing bubble (2005-6). Similarly, Phoenix house prices rose nearly as much as Las Vegas, while the rate of increase per acre in Phoenix land auctions rose nearly as much as in Las Vegas.

Somewhat conspiatorially, a similar situation prevailed in Spain. An Economist article has noted that building on vacant land required local governments to extend town limits, and entitled them to 10% of development land (which town governments then sold for revenue). I find it suspicious that three of the biggest housing bubble markets in the world in the last decade were characterized by these sorts of crony capitalist land ownership rules. It’s easy to imagine how governments could limit the sales in these auctions to artificially constrain supply and encourage price inflation.

I think all of this is at least circumstantial evidence to think that local zoning and housing policy may have played a role in preventing a housing bubble in Texas. There are other factors at play too — Texas has high property taxes, further limiting speculation, and it tends to draw its migrants from states in the Midwest, which also saw low property price appreciation. By contrast, Nevada and Arizona saw a lot of migrants from California (cashing in on previous house appreciation), while Florida had a lot of migrants from pricey New York.

Still, there’s no reason we can’t follow both the consumer regulation and the lax zoning. Texas’ housing policy involves “regulations,” but ought be relatively palatable for regulation-distrusting libertarians and others to swallow. There aren’t strict mandates on what or where to build, but simply sensible rules requiring that homeowners keep sufficient collateral in their homes. This seems reasonable enough. Not to get too into the politics of this, but the chief opposition to collateral requirements tends to come from progressive community activists worried that downpayments punish wealth-poor families.

Meanwhile, the loose regulations on housing seem to do a great deal of good in preventing price bubbles from building up as well. Those, too, seem reasonable. There’s no reason not to adopt both sets of policies throughout the nation. That would lower rents, limit speculation, and likely lower house price volatility. It’s too bad Rick Perry isn’t running on that platform.

The Rentier Class and Monetary Policy

Reihan Salam flags this bit from J.P. Morgan report on why there has been so much resistance to the Fed’s actions:

To understand why, consider Mr and Mrs James Rentier (a), an apocryphal family in their early 50’s living in upstate New York. The Rentiers are middle income: $80,000 in adjusted gross income, 3 children and $300,000 in savings after setting aside 10% of their income over the last 30 years. Over time, as they aged and given their limited safety net, they shifted their investments into cash and short term fixed income. The current tax system is friendly to the Rentiers; at their income level, after standard deductions, available child tax credits and the payroll tax holiday, their fully-loaded effective tax rate is around 14.5%. But now consider the impact of QE (quantitative easing) on this family. Money market yields, in a normal cycle, are ~ 2% over core inflation; that would be around 3.5% today Zerophilia deprives this family of ~$8,200 per year in after-tax interest income. How substantial is that? Let’s normalize interest rates, and then compute the increase in effective tax rates that results in the same amount of after-tax income the Rentiers have today. As shown below, the punitive impact of QE on this family is the same as raising effective tax rates by one third. These are the unintended consequences of QE: a wealth transfer froms avers to the over-leveraged, and perhaps, to owners of stocks, although this latter channel isn’t working that well. Note: this is before considering the impact of rising commodity prices on the Rentiers (the Fed rejects the notion that QE affects commodities).

The implication here is that all monetary policy doe is lower interest rates, serving as an implicit tax on the holders of capital. One hears a lot of this talk, and it’s worth wondering why there seems to be so much political backlash against federal reserve easing actions.

The key here though is that this analysis narrowly focuses on the short-term impacts of easing against the broader impacts. In the short term, more easing (say, in the form of further quantitative easing) may well lower long-run interest rates (the liquidity effect). But in the long run, easing serves to increase total nominal spending, and so expectations of future inflation. This is the Fischer effect, and it works to raise long-run interest rates.

A lot of people seem to be upset right now that interest rates are low; but that’s not

solely a function of the Fed. The “natural” Wicksellian rate of interest is low due to a weak economy. Successfully targeting a future path of nominal spending higher than that expected today would lead to a robust economic recovery and higher inflation expectations — and so actually higher interest rates in the future. That’s why Milton Friedman identified low interest rates with tight, rather than loose, money.

So phrasing this issue as a “economic recovery on one hand, low rates on the other” dilemma is short-sighted. The path to both economic recovery and higher rates lies in more easing. And if you look internationally, the countries that have done the most to implement expansionary monetary policy have the higher interest rates. In Sweden, Lars Svensson has pioneered a variety of unorthodox monetary policy tools — including setting a negative interest rate on reserves, and robust quantitative easing. The result has been an economy that has recovered to a pre-crisis trend rate of growth:

That has provide the Swedish Central Bank with sufficient leeway to see rising interest rates, led by Central Bank rate hikes. By contrast, Japan has been far more reluctant to embrace an expansionary monetary policy in terms of raising its price level; and so has seen low interest rates for decades. It’s hard to think that Japan is a better place for rentiers than Sweden.

There’s been substantial discussion of how it is that people in the economy somehow don’t perceive this. Brad DeLong has argued that the Great Depression era rentier class was opposed to inflation as their profits were entirely insulated from the suffering of common folk. By his argument, people are sufficiently

It’s hard to know what to think about this. The rentier class in the Great Depression was also devastated by overall economic losses. A reluctance to embrace expansionary monetary policy in an environment of a persistent demand shortfall and very low inflation doesn’t seem to make too much private economic sense. One imagines that the rentier class is simply mistaken

The Buffett Op-Ed

Others have already tackled this Op-Ed by Warren Buffett, in which he basically calls for higher capital taxes. Buffett's argument revolves around fairness -- he doesn' t seem to be taxed very much on a personal basis relative to the administrative staff in his office (why he continues to have administrative staff is another story -- one imagines that he could just learn to use Google Calendar, email, and then fire everyone else). The take on the other side is that we ought to set taxes on capital and corporations in ways that make sense for society as a whole, not for reasons of fairness.

And Buffett is absolutely playing this for personal PR purposes -- the more he ostensibly calls for greater "sacrifices" from himself; the more he alleviates any potential sources of envy against his wealth. Buffett may well end up doing better in a world of higher capital taxes, which would place enormous burdens on his competitors. Add to that his own ideological biases, the fact that Buffett doesn't pay many taxes anyway due to the fact that he's donating the vast bulk of his wealth, etc. and you end up with a not-particularly compelling case.

But then you also have some seemingly factual howlers.

Some of us are investment managers who earn billions from our daily labors but are allowed to classify our income as “carried interest,” thereby getting a bargain 15 percent tax rate. Others own stock index futures for 10 minutes and have 60 percent of their gain taxed at 15 percent, as if they’d been long-term investors.

This doesn't seem right at all. I'm sympathetic to eliminating carried interest rules; but it just seems wrong as a factual matter to argue that short-term investment gains are taxed at the long-run rate for those institutions -- or so I glean from Avik Roy. See the new update.

Then there's this section, which is something that Buffett repeats over and over:

Last year my federal tax bill — the income tax I paid, as well as payroll taxes paid by me and on my behalf — was $6,938,744. That sounds like a lot of money. But what I paid was only 17.4 percent of my taxable income — and that’s actually a lower percentage than was paid by any of the other 20 people in our office. Their tax burdens ranged from 33 percent to 41 percent and averaged 36 percent.

Leave aside Buffett's estimation of his own tax liability, which primarily reflects capital gains. How are his other office employees taxed at those rates? After all, one only enters the 35% income tax bracket after $250,000; and even there the average tax liability of a person will be much lower (something like 27% in my calculation). Is his comparing his average tax liability with the marginal tax liability of his employees? In the past, he's frequently claimed to have a higher tax rate than his secretary making $60,000 a year. Yet the marginal tax rate for a single person with that income is 25%. That's of course higher than the 17% he quotes above; but is far lower than the range he provides there (with an average tax liability that is far lower too).

There's much more here that's absurd. For instance:

I didn’t refuse, nor did others. I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.

Why don't we just go all the way up to a tax rate of 90% then if the tax rate doesn't matter? If you think it matters at 90% on some margin, who is to say it doesn't matter at 39.9%? Why on earth do we think that asking investors will yield better information than thinking through data or theory? There's just no reason to think that making lots of money endows someone with insight in public policy or a comparative advantage in Op-Ed writing.

Update: From James Choi, someone with an Adjustable Gross Income of ~$60,000 pays 12.9% of their taxable income as income tax, and 8.5% of their AGI as income tax. Sure, you can add in payroll taxes, etc. in here -- but it's difficult to see exactly where he's getting the "my secretary pays so much more in taxes than me" statistics from.

Update 2: Steve Waldman has more in the comments regarding the tax treatment of futures. Buffett was right about this and I was wrong. It's still somewhat misleading in the sense that it presents an extreme example of short-term trading, when only 10 percent of the gains accrued by partners are taxed overall at the short-term rate. The particular rule behind the mentioned 60/40 split seems reasonable. Buffett's real concern anyway is not with the long/short run taxation of capital; but with carried interest rules and capital taxes generally. And I'm somewhat with him on the carried interest rules.

Unemployment Insurance

Mike Konczal has a post examining Romney’s idea to establish personal unemployment insurance accounts, rather than universal unemployment insurance. This debate gets into the general difference between “liberal” and “neo-liberal” approaches to the welfare state - in which the liberal approach would have the government directly provision goods, and the neo-liberals prefer to set up market structures to handle insurance (with subsidies thrown in for the truly poor). I’m generally in favor of the neo-liberal option; but Mike has had a number of good posts outlining some powerful critiques.

In this case, Mike outlines some research by Raj Chetty showing that unemployment insurance (when given in the form of a lump grant) actually increases the duration that people take to find a job. This makes sense if you think that the unemployed might need more time to find a perfect fit. So the “moral hazard” aspects of unemployment insurance might not be a huge worry; as long as people are avoiding immediate employment with the aim of finding better employment.

I’m fan of Chetty’s research in general, and this study is pretty clever. But it's worth noting other studies have found different effects. For instance, this study by Krueger found that search intensity increases as unemployment benefits decrease; and search intensity increases as benefits are about to run out. That suggests that some sort of moral hazard aspect to unemployment uninsurance isn’t crazy. Chetty’s paper didn’t show that people who waited longer got better jobs — so we don’t know what the value of waiting for a better job is; or whether people really did wait longer with a lump-sum benefit for better jobs.

We also have the advantage of looking at an actual program of unemployment insurance accounts — Chile — which is in general a good advantage of a neo-liberal approach to the Welfare State (balanced budget with flexibility for the business cycle, private accounts for pensions, etc.). This article from VoxEU suggests that an unemployment insurance savings account raises job-finding rates.

Chile’s program combines regular contributions (“split” between employers and employees), along with a common fund partially funded by the government. Upon unemployment, people first draw down their own private account. The key picture is this:

People eligible for the Solidarity fund (ie, drawing down unemployment benefits they didn't pay for) find jobs at much slower rates initially. Meanwhile, among those with personal accounts -- the amount of funding didn't affect the rate at which people found jobs (suggesting that the liquidity effects Chetty focuses on weren't a huge factor, at least here).

There's not an immediate takeaway from this. The authors of that piece emphasize the ability for personal unemployment accounts in diminishing moral hazard and increasing employment. Contrary to that, it's possible that delaying employment led to better labor market outcomes - though we just don't have data on that. Also, you probably want to figure unemployment itself as a bad, and count shorter unemployment durations as a good thing.

Overall, I’d say that Chetty’s research — though interesting — isn’t the last word. His job duration is interesting, but evidence from search intensity suggests that there may be *some* moral hazard here (the Chetty paper had some role for that too). We still don’t know (or at least I don’t know) what the improvement in job quality is for people who take longer to find work. The evidence on an actual personal unemployment plan seems at least somewhat positive.

I do see one important benefit a shift to personal unemployment accounts would get us — it would depoliticize the unemployment insurance issue. Right now, we rely on Congress to go ahead an authorize additional duration for unemployment insurance every time we have a recession. Given that we lack a consensus on how much the government should actually spend or tax, this discussion gets wrapped up in that broader debate, and so you end up with some hostility to what should be a routine automatic stabilizer. If instead unemployment insurance was all handled by personal accounts, one imagines that this debate would go about differently. People would just have access to unemployment insurance and Congress would complain about other things. Seems like a pretty good tradeoff to me.

How Much Does China Contribute to the US Economy?

Via Paul Kedrosky, here is an informative Fed Letter:

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the "Made in China" label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending. This suggests that Chinese inflation will have little direct effect on U.S. consumer prices.

Even 1.35% of the US Economy is significant. But it's a vastly different picture than one gets in the popular media, where Chinese-made goods have seemingly entirely displaced all American production.

Dreaming of A World Without (Public) Debt

If there's one thing the S&P's debt downgrade reinforces -- it's that public debt is bad. It's bad for taxpayers and bad for stability of the financial system. Ideally, we need to get rid of all of it.

The case for debt as a bad for taxpayers is easy enough. We spent some $200 billion every year on net interest on debt, or roughly $2 trillion a decade -- for which taxpayers receive absolutely nothing at all in return. This interest expense wouldn't exist in a world of saner budgeting in which expenses equalled income over reasonable periods of time.

Then, there's the foregone capital gains on that as well. Gilts are tax-free. If we had no debt and investors held the same amount of debt in the form of private debt, the IRS would be receiving a sizable chunk of revenue a year.

In theory, debt financing makes sense if an entity is making some fundamental investment, for which future cash flows will finance future interest payments. But that's not how the government works -- we borrow from tomorrow to finance consumption today. We're paying billions of dollars extra because the folks in 2003 were too short-sighted to finance their consumption in 2003 rather than later. That's no good reason to pay billions in the form of interest payments and foregone capital gains income. Think of how much easier it would be to handle budget problems with that extra buffer. Instead, we're taking those interest payments and throwing those back on the credit card. We'll end up paying substantially more than one dollar in future taxes to finance one dollar of consumption.

Does getting rid of the debt altogether sound crazy? Australia has typically held basically no public debt over the business cycle. They have a little more today due to the financial crisis, but will in all probability wind that down back to basically zero.

Then, there are the warping knock-on effects that "safe" sovereign debt has on the entire financial system. As Perry Mehlring outlined in The New Lombard Street, the Fed was once optimized for a world where the entire system of payments and debt revolved around private debt. What we dub "quantitative easing" was once done sort of more routinely as the Fed manipulated the prices of privately issued debt in order to determine country-wide credit and money ability.

FDR's enormous deficits -- and the resulting stock of public debt -- changed that. The Fed altered its mandate to only mess with public debt, only recovering that old role during the financial crisis, when a zero-rate bound on short-term Treasury debt and broader financial problems brought about financial interventions into private debt. But had FDR not bothered with basically useless fiscal stimulus programs (ie, decided to follow his campaign pledges), and instead stuck with the monetary interventions that actually worked -- we could imagine an alternate central banking world in which shaping interest rate expectations on private debt would constitute the totality of Fed operations. That would have been a much more stable world to live in.

In particular, you don't have the nonsense of "safe" debts underpinning the architecture of the entire financial world. Gary Gorton talks about the creation of structured finance as a way to meet some "shortage" of safe assets provided by the government. I would instead say that the fallacy of assuming that safe assets exist is invariably the cause of financial crises. Rather than worrying about what a debt downgrade will do to the financial system - the goal should be to build a system with is tolerant to (normal! expected!) downgrades of certain types of debt. Rather than pricing everything on the basis of Treasuries, we could have a world where everything has an assumed credit risk, and people bear enough capital to handle expected credit shocks.

This doesn't say anything about the mechanism by which debt goes to zero - whether we get there by higher taxes or lower spending. Obviously, right now, that's hard to imagine. But Australia seems to have figured something out, and even countries like Sweden and Canada have made important steps in that direction. At least in terms of how to imagine debt, I think it's important to say, "piling up this much debt was a really bad idea we should reverse as soon as possible," rather than, "interest rates are low, so let's pile on as much more of this as possible." The price of debt tells us nothing about it's value.

Data Revisions and the Guns and Butter Model

Karl Smith has a request:

Has anyone run the guns a butter model on the last election with the new disposal income data? Supposedly the Dems lost an extra 20 seats in the House or so above what could be explained structurally. However, now that we know the structure of the economy was worse than the frontline data does that estimate still hold?

I haven’t run the numbers but I am guessing what looked to be policy backlash will vanish in the structural void with new estimates.

I decided to check this out. First, I went with Douglas Hibbs site, the original source of the "Guns and Butter" model. He had predicted that the Dems would win 211 seats, roughly an overestimate of 20 seats (relative to Democrat actual wins of 193). However, this estimate came with caveats:

In fact there is uncertainty about income growth during last quarter - the 2010q2. The personal income data for q2 posted by the Commerce Department's Bureau of Economic Analysis on 30 August 2010 are second estimates and they are subject to potentially large revisions later.

Of course, this is exactly what happened.

I decided to download his data and update the consumption statistics. I took the latest disposable per capita income, which have been revised going back to 2008Q1. I couldn't get the CPI data to match exactly, but this page seems to do well enough to deflate the numbers.

At this point, I decided to run the full model with the 2010 election as an additional data point. This is the relevant point to use in evaluating all of the data to use for future modeling; but it may overstate the fit exactly for 2010 slightly. Here's what I have:

The new prediction for 2010 is 202.5 seats. This overstates Dem gains about about 10 seats, but does cut the overstatement.

I wondered how much adding 2010 did on its own, so next I threw out the 2010 data, and fit the 2010 election based on previous election data, but current economic data: now, I get a Democrat prediction of 206 seats. Roughly, a fourth of the Democrat "underperformance" can be accounted for by economic conditions that were worse than thought at the time.

I'm not sold on this model -- with so few elections to go through, it seems likely that many elections will be "anomalies" ex ante and then rationalized ex post through the model (you can sort of see that here -- throwing in the new data lowers the rate of misfit for 2010). Plus there are the various structural reasons to mistrust any model like this - Andrew Gelman offers some comments here, and then there is the Lucas Critique.

But if you're looking for ways in which worse economic data should change your priors, here's one of them -- the Democrats faced a worse economic climate in 2010 than commonly realized, and their performance is more understandable as a result.

We Should Have Defaulted

Any particular reason why we had a market crash now? Wasn't the extension of the debt ceiling supposed to ward off a market collapse? Arnold Kling offers a contrarian take:

Apparently, the resolution of the debt ceiling restored the dollar's status as a safe haven in the eyes of the world's investors. That accelerated the flight from European sovereign debt and European banks. That in turn raised fears in financial markets, driving down stocks, including in the United States.

I think one can make a plausible argument that we would be better off continuing debt ceiling games in the US. It looks as if certain European countries -- the usual suspects of Italy, Greece, and Spain among them -- face self-fulfilling beliefs regarding the quality of their debt. They can survive only if investors continue to lend to them at low rates. There are multiple equilibria here -- either peripheral countries continue to borrow at cheap rates reflecting a low probability of default, or they borrow at high rates reflecting a high probability of default.

Which equilibria we are in is determined by the initial level of capital willing to invest in Europe versus America. As Kling points out, the resolution of "uncertainty" in the US shifted the balance in favor of the US, pushing Europe to the bad equilibrium, with internationally disastrous consequences. Of course, keeping America a risky destination for capital probably isn't the best long-term strategy. But perhaps a more stringent regime of capital flows could have alleviated some of the short-run European liquidity problems, buying time to deal with the solvency concerns.

Elsewhere, Ryan Avent offers a useful historical perspective comparing today with the 1930s. It is a useful analogy, one that largely fits the narrative I got from the excellent Wages of Destruction. The euro, in this reading, in some sense serves the same function as the Gold Standard did for European countries -- a straightjacket preventing adequate monetary easing in poorly functioning economies, who have contracted out the ability to ease and do not receive fiscal transfers from elsewhere.