Calculated Exuberance

Individualism and the State

2012-01-15T21:26:00.000-08:00

Robin Waterfield's Dividing the Spoils focuses on the dawning of the Hellenistic Age after the death of Alexander the Great. He observes:

One of the most striking aspects of the Hellenistic period, by comparison with what came earlier, is its focus on the human individual. Social historians agree with historians of philosophy, art, and literature that this phenomenon is characteristic of the age.

Waterfield makes the link between this growth of individualism and the parallel rise in state absolutism:

By directing citizens’ energies toward the good of the state, the system allowed poleis to flourish, but the price was a higher degree of collectivism than most of us would find acceptable today. By contrast, we consider ourselves free the more we are able to avoid or ignore the state apparatus and remain within our private lives. A citizen of a Classical Greek polis had a far more restricted sense of privacy. Almost everything he did, even fathering sons and worshipping gods, was done for the good of the state—that is, for the good of his fellow citizens.
The Macedonian empire, however, changed the rules. Although poleis retained a great deal of their vitality, the inescapable fact was that they had become greater or lesser cogs in a larger system....

The relative disempowerment of citizens as political agents that happened as the Hellenistic empires centralized power made it possible for people to see themselves, to a greater extent, as individuals, rather than just as contributors to the greater good. Rather than acting as a liberating force, it seems that the communitarian focus of Greek poleis was actually quite corrosive to individual self-expression. One thinks of Plato's Republic for one.

Waterfield goes on to observe how Hellenistic philosophers, like the Cynics and Epicurians, focused on individual esteem, as opposed to relationship between the individual and the state. Similarly, religious mystery cults offered personal emotional salvation. Women, too, saw large gains, enjoying far greater freedoms in the Hellenistic period than before. Even slaves seemingly were more often freed in this period.

Waterfield also connects these individual-level shifts with the broader political picture, which saw a host of post-Alexander successors contesting for territorial supremacy:

In the Classical period, this individualist form of greed was invariably regarded as a particularly destructive and antisocial vice, and it was expected that the gods would punish it or that it would arouse fierce opposition from other humans. The historian Thucydides, for example, thought that Athenian overreaching was one of the main reasons that they were defeated in the Peloponnesian War. The Successors trampled on such views. For them, and for all the Hellenistic kings who came after them, greed was good. Individualism and egoism are close cousins.

This reverses most of the typical associations. One typically thinks of political enfranchisement as going together with broader self-actualization; and greed as a corruptive force. We tend think of absolutism as the greatest enemy of individual agency. Waterfield suggests that, at least in one context, those relationships don't necessarily hold.

I find this a puzzling mix of strongly pro- and anti-libertarian attitudes. One one hand, this suggests that individual attachment to the state happens to the detriment of other aspects of individual flourishing; and that social mores encouraging egoism can promote individualism. On the other hand, it suggests that removing individual participation from the workings of the state is the best way to liberate people from this greater burden of being constrained by the forces of political participation.

Schumerism

2012-01-06T16:39:00.000-08:00

Here's a brief essay expanding on a post I made at The Agenda:

The typical discussion of the middle class begins with a tale of statistical woe. We are often told, for instance, that median household disposable income has remained virtually flat from in the last several decades. Strictly speaking, this is true. Such examples of middle class compression form the basis for narratives of how the American dream is being crushed and requires an active countervailing force to resist that pressure.

Chuck Schumer has done more than virtually any politician in voicing that narrative. Yet his success comes in equal measure from voicing tales of doom, as well as cannily recognizing the ways in which middle America has changed in order to offer up government solutions to satisfy people's new needs. To the extent that we confront a larger government, it is because Americans have increasingly bought an ideology — “Schumerism” — that sells government spending as the solution to the problems of an increasingly affluent middle class.

This rising wealth stems from the continuous productivity advances of the last several decades, which have yielded enormous improvements in the typical American quality of life. One telling statistic comes from the CBO, which estimates that a typical family of four received in 2010 an overall pre-tax compensation of $94,900. In some sense, the vast majority of Americans are millionaires — not of course in terms of their immediate access to assets, but rather in the raw earnings potential a typical family can expect over a lifetime. This reflects a degree of prosperity unimaginable in 1958, when John Kenneth Galbraith already considered the pattern of private wealth to constitute unbelievable affluence. Families with two-earners or more education than average can expect to earn even more.

Thus, in comparisons with generations past, Americans find themselves with a lower need for government than ever before. If the goal is simply to ensure a basic absolute level of income, the insurance and welfare aspects of government are less necessary than they ever have been.

That simple economic logic has had drastic implications for both political parties. Democrats in particular have been forced to adapt to new economic realities. Their core constituencies have simply evaporated as the working class has graduating in income; College education has increasingly become the norm; and union membership has plummeted. If the voting patterns based on education and income had remained fixed from, say, the 1970s -- Democrats would simply be politically annihilated. In order to remain electorally viable, Democrats have been forced to appeal to the demands of an increasingly wealthy and educated public.

This appeal has rested on a potent and incisive understanding of the demands of wealthier households. As an Atlantic profile of Chuck Schumer explained:

“A lot of times, what Democrats say are the struggles of the middle class are not really the struggles of the middle class,” says Jim Kessler, a longtime Schumer adviser and a vice president of Third Way, a centrist Washington think tank. “They’re the struggles of people who are actually poor. So when people in the middle class hear you talking about these things and calling them middle-class problems, they actually think you’re talking about someone else’s problems.”

For Chuck Schumer and other politicians from both parties, this represents potential crisis as well as an opportunity. Conceivably, the rising affluence of the middle class could result in a lower dependence in government. But if politicians could target the new demands of increasingly wealthy households, government could expand to fit new niches. The result has been a government increasingly tasked with handling the pressures of new middle class life.

A full reckoning of these programs begins with the tax code and the various deductions that enable off-balance sheet subsidies to favored consumption categories. The Treasury estimates that all income tax expenditures will reach $1.2 trillion in fiscal year 2011. The largest of these categories include the exclusion for employer-sponsored health insurance and the mortgage interest deduction - both of which subsidize middle class consumption of healthcare and housing.

The universal nature of Medicare and Social Security constitute the two other pillars of government spending. Regardless of the essential merits of these programs, their universal status guarantees millions in subsidies to Americans capable of financing their own retirement and future health expenses.

In the pivotal areas of government focus — housing, healthcare, and education — the genius of Schumerism lies in government's ability to sell itself as a solution to problems created by its other various branches. For instance, as the Economist Ed Glaeser has emphasized, high housing costs faced by residents of the coasts areas owe in large part to onerous restrictions on construction and rent control. Yet instead of supporting free market attempts to cut down on such regulation, such housing policies generate additional pressure to regulate housing prices or generate additional housing finance to make home purchases more affordable.

The same is true in education. Education costs have spiraled in part due to increasing demands for educational amenities. For instance, the student-teacher ratio has plummeted from 22.3 to 15.6 in the last forty years, while educational facilities are better than ever. The stranglehold that public provision and unions place on the structure of K-12 education has ensured steady inflation in education costs. Yet politicians have successfully sold parents on the idea that the real problems with education lie in insufficient funding for their local schools -- to be financed through additional rounds of government funding.

In healthcare, the imposition of government mandated fee-for-service has been directly responsible for spiraling growth in this sector. Amy Finklestein, an Economist at MIT, for instance has roughly estimated that roughly half of the increase in real per capita health spending from 1950 to 1990 may be accounted for by the spread of insurance - in particular government mandated insurance. Medicare has enshrined a low-deductible fee-for-service model that is popular with voters, but has proven destructive to pocketbooks. The healthcare deduction provides additional incentives for labor compensation to be drawn in the form of health insurance.

Yet the resulting high costs of healthcare become arguments for why additional subsidies and regulations are required. The latest iteration of this vicious cycle is PPACA -- another system of subsidized insurance coverage (again, for increasingly wealthy Americans) who cannot afford insurance in government-fixed markets.

The final mechanism of creeping demands for government support comes through taxes. It is true that taxes, as a share of GDP, have remained relatively constant; and that marginal tax rates are relatively low by historical standards. But if the tax burden has remained constant in the face of rising GDP -- that implies a government growing at the rate of income. Even as we have become richer and better capable of weathering the storms of economic insecurity, the government has steadily found new programs to satisfy new demands created by more income.

The cost of these programs has taken a heavy toll on the middle class's balance sheets. In The Two Income Trap, Elizabeth Warren and Amelia Tyagi painted a dire picture of middle class evolution by presenting the balance sheet of one family in the 1970s and another in the 2000s. The two families, the authors argue, end up with a similar discretionary income - a sign of the middle class’s stagnation. Yet as Todd Zywicki has pointed out, a key factor behind this seeming stagnation is the fact that a typical family in this situation can expect to see their tax liability grow by 140%.

The result has been a middle class pressure cooker. If families don’t feel as rich as the $94,000 they receive in compensation, it’s because households have felt their post-tax compensation suffer due to a variety of cost pressures — coming either directly from the government (in the form of higher taxes) or indirectly in the form of greater regulations and higher costs in fields like housing and healthcare. Yet rather then offering fundamental reforms to alleviate those cost pressures, politicians like Chuck Schumer have instead offered individualized government programs as the solution. The benefits of those programs are clear and immediate to struggling households; the long-run costs are less visible but serve to escalate the long-run cost pressures and create demand for future entitlement and public spending.

Another form of relief has come from extending lines of credit. Wall Street and big government have common interests in many fields, a relationship personified by Chuck Schumer’s excellent finance contacts. Wall Street is happy to purchase government debt and extend credit to consumers. As Raghuram Rajan argued in Fault Lines, increases in credit serve as another palliative to the fundamental stresses in the middle class balance sheet — stresses induced in no small part by the government. Fannie and Freddie, too, drastically expanded their operations starting in the late 90s. Today, the federal government backs over 58% of the mortgage market, including virtually all new mortgage originations. This flow of credit enables the sort of housing consumption that the new middle class demands, but cannot afford due to cost pressures elsewhere.

Collectively, in essence, we have decided to delegate the task of household consumption. Instead of purchasing goods ourselves, we have the government spend and regulate consumption for us. Such a decision might have made some sense if the government were an effective arbiter of spending. Unfortunately, it is not -- too many government programs are badly functional and breed the very cost pressures that they were designed to counter.

It is easy to see how the broad coverage of such government entitlement and spending programs might generate instant political appeal. But the demands to ensure universal access to such programs have another source -- the belief among many liberals that programs meant for the poor will be poorly funded. The argument goes that even if universal access and broad spending may benefit individuals who strictly speaking could afford services on their own; such buy-in is essential to ensure the continued stream of services to the truly needy. The richer, in this reading, cannot truly empathize with the poor unless they receive the same services -- so it's essential to ensure that the rich continue to consume Medicare and send their children to public schools.

The logic behind this sentiment is questionable. Medicaid, for instance, has seen steady rises in public funding over the decades, even if recessions leave state governments temporarily stressed and reluctant to expand that program. It's not at all clear that buy-in from relatively prosperous sections of society is necessary to ensure the continued success of public programs. Many European countries for instance combine greater spending on the poor in relative terms with more expansive spending in general — while America directs a greater proportion of government spending to the rich.

But more fundamentally, ongoing fiscal challenges will heighten the challenge of large-scale spending on both the middle class as well as the poor. Rather than serving as the guarantee that the poor will receive sufficient spending of their own, middle class entitlement programs increasingly compete with those programs for funding. And the political life that they have taken on ensures continual sources of funding, while programs for the poor are increasingly on the cutting block.

In an age of austerity, we can no longer afford an expansive welfare state — at least without corresponding increases in taxation that even Democrats have been reluctant to endorse. Yet the pressures of an aging population and rising healthcare costs will result in enduring budgetary costs. The only solution is to trash Schumerism, and accept that increasingly affluent Americans must pay their own way.

War for US Capital Markets

2012-01-04T14:56:00.000-08:00

I have an op-ed with Chris Papagianis at Forbes I've been meaning to link to for a bit. Here's a sample:

The private sector is fighting the government for control of capital markets, and the government is winning. The most recent data from the Federal Flow of Funds reveal that Uncle Sam stands behind over 58% of the mortgage market – a hike of 13 percentage points since 2006.

But it has now been three years since the fall of Lehman Brothers, and the grip of government-backed finance is still tightening as opposed to letting up. On October 20, 2008, the Washington Post ran the headline “Is Capitalism Dead?” This question and the short-lived philosophical debate has now faded, yet a fair reading of capital market data today indicates that the two sides are still battling.

We are now at a point where it is almost impossible to imagine a functioning capital market without an oversize role for government. The longer the government maintains a dominate role, the more the private sector’s capacity to fill in or take control atrophies. This dynamic needs to shift back in the direction of the private sector. In many ways, the most important battle the U.S. faces over the next few years is wrestling back control of its own capital markets.

Labor Supply and Taxes

2012-01-04T14:53:00.000-08:00

I have a post at The Agenda on the impact of taxes on labor supply:

While many recent discussions of tax policy are motivated by using taxation for the purposes of economic stimulus or for addressing income inequality, the really important long-term impacts of taxation center on labor supply. Higher taxes induce people to cut back on hours worked (what economists refer to as the intensive margin), as well as to drop out of the workforce entirely (the extensive margin). Figuring out how much taxes induce household labor behavior along these dimensions has been a major area of economic research, and the implications for government policy are sizable...

Broadly, macroeconomists like Ed Prescott, studying the behavior of economies in the aggregate, tend to prefer large labor supply estimates; while microeconomists like Saez and Diamond, studying groups of individuals, tend to support smaller estimates. This empirical dispute has fairly far-reaching consequences on the structure of government policy. If Diamond and Saez are right, then even large hikes in taxation, though they may affect after-tax income, will not impact labor supply or GDP. If Prescott are company are right, then hikes to marginal tax rates will hit labor supply, and through that GDP, and so damage a key source of competitive advantage for the US economy...

In the midst of continuing economic woes, there is little appetite to raise taxes on anything but a tiny fraction of Americans. Yet, eventually, politicians will face difficult fiscal choices. Raising taxes may avoid difficult cuts to social spending programs; yet there is a sizable body of research that suggests higher taxes may have long-run consequences on the long-run success of the economy — which will in turn make it more difficult to balance Debt/GDP. This may still be a choice worth making. Yet it is important to keep in mind the tradeoffs that higher taxes imply. At the very least, it’s a reason to pursue tax reform that lowered marginal tax rates by broadening the tax base, which would improve economic efficiency with few economic costs.

More on Repos

2012-01-02T22:00:00.000-08:00

After my last post on this, I went to look up some more facts on the repo market. This issue concerns not only the importance of "safe assets," but also the role of the repo market failure in precipitating further financial market instability. I ran into a paper by Krishnamurthy, Nagel, and Orlov that provides new data and presents a revisionist take on the role of repo in the shadow banking system. Here are some principal quotes:

The table also details the amount of these securities financed by repo. Total repo of non-Agency MBS/ABS is $171bn. Even if we include the repo extended against corporate bonds, the repo total is only $386bn. This is a small fraction of the out- standing assets of shadow banks. This observation underscores a principal finding of this study: repo was of far less importance in funding the shadow-banking sector than is commonly assumed.
If repo was not the principal source of funding, what was? The table details the direct holdings of these securities by MMFs and security lenders. The direct holdings are substantial, totaling $745bn. It is likely that such holdings are high grade and short maturity tranches of securitization deals...

First, while in their data average haircuts are frequently zero in 2007 for corporate debt and securitized products, the repos undertaken by MMF in our data always have average haircuts of at least 2%, even for Treasuries and Agency debt. Second, although our value-weighted averages (which is the most relevant measure of aggregate funding conditions) are difficult to compare with the equal-weighted averages in finer categories reported in Gorton and Metrick (2011b), an informal comparison suggests that haircuts in tri-party repos of MMF increased much less than the haircuts in their bilateral repo data (Gorton and Metrick report average haircuts in excess of 50% for several categories of corporate debt and securitized products).

Taken together with our findings of the relatively small amounts of MMF repos against private-label MBS and ABS collateral, these observations suggest that the “run on repo” may have had a more modest effect on aggregate funding conditions for the shadow banking system than what one may guess from the enormous increase in haircuts for securitized products in the bilateral repo market as reported by Gorton and Metrick (2011b)...

This finding does not support the emphasis that Gorton and Metrick (2010, 2011b, 2011a) and Adrian and Shin (2010) have placed on the repo market in explaining the collapse of the shadow banking system. Instead, the short-term funding of securitized assets through ABCP and direct investments by money market investors are an order of magnitude larger then repo funding, and the contraction in ABCP is an order of magnitude larger than the run on repo. Troubles in funding securitized assets with repo may have been a major factor in the problems of some dealer banks that were most heavily exposed to these assets, but for the shadow banking system as a whole, the role of the repo market appears small.

These results are in strong contrast to Gary Gorton's work, which has focused on the bilateral repo market. His research suggested that the financial crisis could be understood as a bank run similar to past financial crises, as in the 1930s. However, in this case, the bank run simply came instead to the shadow banking system in the form of the repo market closing up. The implication is that much of the fallout in the last several years can be understood using the same framework for why maturity mismatch induces normal banks to face runs.

The results from Krishnamurthy and company are in some tension with this interpretation. Repo by itself seems to have constituted a small share of financing in the shadow banking system. Correspondingly, the "run" on repo had little impact on aggregate bank financing systems (though painful for certain individual banks). The run was concentrated on repos collateralized by private label AAA securities, not on repos in general. Even risky banks were able to obtain repo financing by collateralizing with different securities.

Meanwhile, repo haircuts for some assets mirror their levels during the crisis. This seems inconsistent with the idea that the crisis involved some extraordinary and temporary run, as opposed to a general shift in the attitude towards the risk of certain assets.

To be sure, the results are specific to repo supplied by dealers and money-market-mutual funds. It seems likely that their financing supply remained more inelastic throughout the crisis compared to financing between banks, which decreased dramatically in response to a credit crunch environment.

It's interesting to compare this narrative with Ivashina and Scharfstein, who argue that new bank lending had begun to decline in 2007Q3, well before the turmoil in repo/shadow banks became more pronounced. A GNI approach to the economy shows stagnation in this period as well, while mortgage defaults were starting to kick in.

One story consistent with all of this would emphasize the role of deteriorating productivity and credit conditions throughout the crisis, combined with a shadow-bank driven monetary crunch in 2008. Stagnating income for a substantial period of time induced higher levels of household borrowing; defaults on which triggered bank retrenching. In turn, this induced short-term financing effects that were important, but largely limited to inter-bank financing. The bank repo effect, however, comes with a money multiplier that continued to further amplify the crisis.

Safe Assets, MBS, and Sovereign Debt

2012-01-02T15:08:00.000-08:00

David Beckworth kindly links to my last post on safe assets:

Gupta also makes some other points, but this is his main one. His point sounds reasonable, but I wonder how important this effect is explaining the overall trend. As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble. It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets. And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire. Is Basel really more important than all these other factors?

This is a fair point. It’s tough to figure out how important Basel regulations might be relative to all of the various other factors driving the use of AAA-rated securities.

First, I would point to role of various policies in driving the growth of repo to begin with. Martin Oehmke has two recent papers that touch on this issue. The first, with Patrick Bolton, argues that the super-seniority given to derivatives like repo under the bankruptcy law results in a socially inefficiently large repo market. The argument is that granting derivatives higher status in bankruptcy (done in the 2005 bankruptcy reform) induces firms to invest far more in derivatives. The issue is that expanding derivative contracts is equivalent to creating high-seniority collateralized debt; and in the event of default, derivative counterparties can seize that collateral even as other creditors are subject to an automatic stay. As a result, firms want to take advantage of the repo market as an additional form of risky investment. The authors argue:

Our model thus predicts that under the status quo equilibrium derivative markets will be inefficiently large: the positions taken in derivatives, swaps and repo markets will be larger than is socially efficient. This incentive to speculate disappears if the special treatment for derivatives in bankruptcy were removed. These results are consistent with the view that the special treatment of derivatives in bankruptcy may be one of the driving forces behind the tremendous growth of derivatives, swaps and repo markets in recent years. In particular, it may explain the increase in the size of derivatives markets since the 2005 bankruptcy reform, which widened the set of derivatives and types of collateral assets to which the special bankruptcy treatment applies.

Another paper by Oehmke and Markus Brunnermeier expands on the short-term basis of financing contracts. Starting with the standard Diamond-Dybvig model, the trend has been to see maturity-mismatch in bank financing as in some sense inherent to the act of banking. Others, such as Diamond and Rajan, have articulated other motives for having banks lend for long-term loans while financing themselves through short-term debt.

Oehmke and Brunnermeier instead develop a model in which banks come to rely on an inefficiently large amount of short-term financing. The issue here is similar as with repos: short-term debt contracts induce externalities on the other creditors to a bank. Shortening one form of financing allows that creditor to update their contracting terms more frequently in response to fast-changing information, as happens for instance during a period of financial crisis. As a result, there is a maturity “rat-race” in which pressure from creditors results in a level of short-term financing that needlessly encourages bank runs and financial crises.

The reason this matters is that the role of safe assets in Beckworth/Gorton’s model comes in exactly as collateral to fuel repos. To the extent that repos themselves are risky and socially wasteful, a lack of assets to fuel there growth may not be very troubling.

Then there’s the issue of how important Basel ratings were in determining the choice of assets, as opposed to various other factors. As I referenced earlier, Jeffrey Friedman and Vladimir Klaus make the argument extensively in Engineering a Financial Crisis that the advent of Basel-II and the Recourse Rule was associated with a dramatic level of bank interest in AAA-rated securities. The present the following graph, which shows the regulatory nature of capital adequacy regulations:

That is, Basel-II (and its US counterpart in the Recourse Rule) dramatically reduced the amount of regulatory capital needed as a hedge against high-rated assets. As Friedman and Klaus discuss, this had an enormous impact on the incentive for banks. While unsecured lending or traditional mortgage lending carried large capital buffer requirements, holding AAA-rated debt carried very little capital requirements, leaving open bank capital for other purposes. Friedman and Klaus argue that this rule change was behind the enormous surge in interest in AAA-rated mortgage securities. They document how the growth in private-label mortgage securities took off in 2002, just as the regulations came into effect, and how banks came to hold hundreds of billions in AAA-rated securities on their books. Hyung Shin, too, has described how European financial institutions came to hold large amounts of AAA-rated securities on their books. This pattern doesn’t explain the repo/safe asset explanation. Nor do typical explanations for the credit boom suggest why capital was directed towards mortgages specifically.

All of that applies to mortgage debt; but a similar story can be made for sovereign debt. As with high-rated mortgage securities, regulators ensured that holdings of all European sovereign debt needed to carry no additional capital buffer. This decision dramatically lowered the yields on European bonds, and falsely declared an actually risky asset (sovereign debt) to be risk-free. European banks, in particular, came to hold enormous quantities of risky European sovereign debt on their books — again, not for the purposes of conducting repo, but as part of their traditional lending portfolio. The whole problem with the European debt crisis recently has revolved around the fact that this debt was not, in fact, risk-free. Ratings downgrades have now left European banks scrambling to raise new capital, while the threat of actual sovereign default threatens to make insolvent major financial institutions and their counterparties.

None of this is conclusive, and records of actual holdings of actual assets by particular banks is hard to come by. Still, I believe it adds up to at a plausible case for why rather than thinking there is a genuine shortage of safe assets, instead regulatory changes have unnecessarily encouraged short-term financing and ratings-driven investment.

Is There a Global Shortage of Safe Assets?

2011-12-26T20:59:00.000-08:00

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

2011-11-27T19:49:00.001-08:00

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

2011-10-08T15:33:00.000-07:00

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

2011-09-01T15:46:00.000-07:00

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 hasplummeted, while the price of credit default swaps to protect against defaulthave 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 thistrigger price, he will then automatically put this plan into action…

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

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

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

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

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

Unfortunately, it seems unlikely, however, thatGeithner and colleagues will actually follow the rules-based back up outlinedabove. Instead, if Bank of America requires a bailout, it will happen in asimilar manner to the bailouts during the financial crisis — which were ad hoc and driven by regulatorydiscretion.

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

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

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

Teaching Practical Math and English

2011-08-25T07:30:00.000-07:00

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?

2011-08-22T11:00:00.000-07:00

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

2011-08-20T16:55:00.000-07:00

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

2011-08-18T17:08:00.000-07:00

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

2011-08-17T16:27:00.000-07:00

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

2011-08-15T12:22:00.001-07:00

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

2011-08-15T11:29:00.000-07:00

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?

2011-08-08T14:57:00.001-07:00

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

2011-08-07T21:01:00.001-07:00

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

2011-08-05T15:34:00.000-07:00

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

2011-08-04T14:52:00.000-07:00

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.

Why the Focus on Government Spending?

2011-08-03T15:45:00.000-07:00

Once, economists believed that fiscal stimulus was basically worthless, and monetary policy determined cyclical variations. For instance, here is Paul Krugman in 1997:

Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God

Though I can't find it; I've seen a policy bit from Larry Summers dating from the '80s or so that was extremely dismissive of the possibility of any fiscal stimulus. This sort of general impulse had knock on effects on all sorts of other policy debates. For instance, future Obama Administration official Jason Furman argued in favor of Wal-Mart in a Slate debate, in which one of his points was:

I believe that Ben Bernanke and the Federal Reserve decide the total number of jobs nationwide.

The general idea was that -- let's hand off the task of aggregate demand management to the Fed, and then otherwise pursue as many pro-growth strategies as possible. Who cares if Wal-Mart costs a few jobs somewhere? The Fed will create them elsewhere. Who cares if free trade results in the loss of a few jobs in Ohio? We'll make enough money from positive-sum trade interactions to make the deal worthwhile, and possibly redistribute back to those newly unemployed. With a strong economy, hopefully they can be retrained and find new jobs.

One of the things that we've seen in the last few years is that this belief has broken down entirely. No one seems to believe that the Fed bears the brunt of the work in generating jobs; or that fiscal stimulus is a typically unworkable solution to economic woes. Instead, we've come to see the economy overall as "Y = C + I + G + X" and think "If government spending goes down even a little bit, the economy will grow unacceptably slowly." More generally, the sorts of positive-sum economic interactions we loved in the past are less popular, because any negative side effects they generate are seen as imposing unacceptable burdens on struggling folks.

And so you have various people complaining about what this debt deal or what future cuts will have on jobs. This is just a type of debate we never really had before now; in the early 2000s for instance, you had the Republicans proposing a "Keynesian" strategy of lower taxes, while Democrats opposed that. But the aggregate demand management aspect of those cuts was less important than their inherent value as tax cuts.

Opinions on the composition of government spending or taxes differ. We should, in theory, be able to have perfectly reasonable discussions about how much we ought to spend or tax without worrying inordinately about how those discussions affect the labor market. If a central bank is properly targeting inflation or the price level, it will lean against government spending in either direction, meaning that no level of government spending has any effect on the economy in aggregate. That way, we can spend all of our time arguing whether or not any particular spending or tax bill makes sense on its own merits. People back in the '90s and '80s had the right idea.

We've sort of stopping doing that. A strong goal on the left seems to be ensuring that government spending remains as high as possible; because otherwise that will ensure doom to a poorly functioning recovery. On the right, the goal too is to keep taxes as low as possible, because households too are struggling. Perfectly reasonable policy debates have become infected with the idea that the balance of public spending and taxation is the primary determinant of broader economic outcomes. So you can't argue in favor of any sort of spending cuts without being some kind of economic arsonist.

I suppose one critique of this is that given such a large output gap and a Fed unwilling to adopt price-level targeting, an inordinate focus on the total amount of government spending makes sense. My response is that it must surely be easier to have the Fed do now what it did during the '90s, so Krugman can again write about how the unemployment rate is set by the Fed, so politicians can spend and tax as they please.

There's the other critique I guess that monetary policy can't perform the same function now due to the zero rate bound, or weak banks, or struggling households. All I can say is: there is an enormous literature on monetary policy, and exactly none of it focuses on the barriers to monetary policy, as least as far as I know. None of it says, "monetary policy works if X, Y, and Z happen." Monetary policy just works, at least in theory.

In practice, we saw monetary policy drive the recovery in 1933 when FDR took the US off of the gold standard, in an environment in which we also were at a zero rate bound; faced weak banks; and financially indebted households. The initial reaction of the economy to the first round of quantitative easing under exactly these conditions was positive; as was the reaction in the second round. The only real counterpoint seems to be the case of Japan. Yet as Scott Sumner has mentioned repeatedly; the Japanese Central Bank really seems to behave as if it does like a zero percent rate of inflation, and QE has helped them maintain that.

But fine, suppose you say I'm crazy for focusing on monetary policy so much. What about other broader labor market policies? Garett Jones links to a paper on the German labor force experience, which basically finds that their flexible labor markets did a great deal to limit the employment impact of the Great Recession. Why isn't there a greater focus on generating specific policies to target unemployment, rather than worrying every time the government spends a penny less?

Guest-Blogging at The Agenda

2011-08-02T11:51:00.001-07:00

The last week, I did some blogging at Reihan's blog. Here's a rundown:

Why the Slow Recovery? - Household balance sheets, not shadow banks, are responsible for the weak recovery.

Examining Geithner's Career - Geithner has failed upwards for over a decade now.

Metis and Salman Khan - This guy is amazing

An N-Shaped Kuznets Curve? - Differences in human capital determine differences in income now, not differences in industry

Mend the Ratings Agencies - Here's what to do about your irrational dislike of Moody's

The End of Administrative Assistants - We have fewer secretaries now, and I'm fine with that

Taxation is Theft - An exploration of what I call "Schumerism" -- the dependency of the middle class on government

Why Are Wages Nominally Inflexible?

2011-08-02T11:29:00.000-07:00

Nominal wage inflexibility is the standard assumption in economics, and it drives many of the key results in macroeconomics. Fiscal and monetary stimulus, in particular, are frequently justified on the grounds that greater price inflation is needed to re-adjust real wages in a world where nominal wages can't go down.

Well, why not? Scanner data shows that goods prices are actually quite flexible even in the short-run, contrary to what a "menu cost" argument would have you believe. Financial prices of course adjust at the level of microseconds. So it's not that prices in general are inflexible downwards -- just wage prices.

Bryan Caplan raises this issue, arguing that workers who offer to work for less "sound weird." That sounds about right. But why? Here's what's going on on either side of the labor market relationship:

1. From the employees' point of view: they're aware that a situation with a lot of unemployment generates a market for lemons. The long-run unemployed tend to be different from those who are employed -- they may not even compete for the same jobs. Yet workers have much more private information on their own about their own capacities than employers.

So you have asymmetrical information. How do workers signal to employers that they really are more qualified than all those people in the unemployment rolls that really do lack skills? These sort of labor search questions are a bigger deal during a severe recession, in which you have a greater mix of people with and without usable skills, when you worry about the depreciation of human capital among the long-run unemployed, etc.

If you walk up to an employer and say, "I'll be willing to work for 10% off;" you basically signal to that employer that you are worth less than the other job-seekers queuing up at the door. If employers were able to perfectly measure skills, they might be willing to take a chance on you anyway knowing that they're either getting a good worker at a lower price, or at worst a worse worker at a dearer price. All they can see in reality is that you have some level of ability that's hard to measure -- but you apparently lack enough confidence in your own ability to get a job that you're willing to lower your wage. That's not a good signal. If you have access to many other job-seekers (say, it's a recession and many people are unemployed) it's easier to go for those workers.

2. From the employer's side, you worry about the morale and productivity among all of your current staff. It's very damaging to morale, it seems, to simply cut the wages of current workers -- perhaps they consume many commitment goods, and even small wage cuts result in costly cutbacks among the few categories of discretionary spending that workers have. Maybe they're just psychologically drawn to "make more" over time, and don't like going backwards.

Either way, you worry about the productivity of workers that you get pay on the cheap. Instead, you want to pay wages that are a little above the market wage to grab workers of slightly better quality. Perhaps you manufacture an O-Ring style product in which outstanding effort from all workers is essential to the final product. In that case, you really worry about the maximum productivity of your worst employee. Grabbing minor wage savings from a marginal employee is a second-order consideration relative to lowering company-wide productivity that can happen from offering even a few workers lower than market wages.

Again -- you're not going to be hiring the best workers at a lower wage. The best workers are confident that they can actually get a good wage. The information asymmetry problem here is tough, and prices here are used as signals more than incentives.

There's a huge literature on this subject I'm not familiar with, so I'm sure others have had similar thoughts. This is what I would look to though.

The Lucas Critique

2011-06-30T01:14:00.000-07:00

One of the most powerful ideas in economics is the Lucas Critique. The notion is that statistical relationships estimated in historical data do not necessarily represent causal relationships manipulable by policymakers. It applied in particular force to the Phillips Curve, a connection that some researchers found between unemployment and inflation. According to this critique; simply observing that unemployment and inflation tend to move opposite one another does not mean that central bankers can push inflation higher at will and gain lower employment.

This was a powerful critique at the time, and has yet to penetrate a lot of economic talk. Here, for instance, is Christina Romer, former Chair of the CEA:

The real division is not about the acceptable level of inflation, but about its causes, and the dispute is limiting the Fed’s aid to the economic recovery. The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

It seems that Romer is accepting not only the empirical Phillips Curve relationship, but also its causal ability to be used by central bankers. Not only is this her own opinion, but the view that ought to be held by "empiricists" who are rigorous in the way they face data, as opposed to those woolley-headed theorists.

Yet even the empirical relationship between unemployment and inflation has broken down in the past few decades. And even if one such relationship did exist, that would not necessarily provide a guide for monetary policy. I do agree that more monetary easing would be worthwhile, but this is a bad way argument in its favor.

On the other side, you have other individuals arguing against monetary easing on the grounds that higher structural unemployment makes monetary easing futile. Scott Sumner neatly addresses that argument:

For similar reasons there is no hard and fast distinction between cyclical and structural unemployment. For instance, if structural unemployment in American has risen closer to European levels, it may be partly due to the decision to extend unemployment insurance from 26 weeks to 99 weeks, and to increase the minimum wage by over 40% right before the recession. Does that mean that demand stimulus cannot lower unemployment? No, because the maximum length of unemployment insurance is itself an endogenous variable. If stimulus were to sharply boost aggregate demand it is quite likely that Congress would return the UI limit to 26 weeks, as it has during previous recoveries. For similar reasons, the real minimum wage would decline with more rapid growth in demand. Aggregate supply and demand are hopelessly entangled, a problem that many economists haven’t fully recognised.

Once again, some relationship we observe today ("there is more structural unemployment now") doesn't provide an unambiguous guide on what to do in the future.

Finally, here’s a recent example from India’s Economist Prime Minister, Manmohan Singh:

We are committed to a growth rate of 9 to 10 % per annum. Our savings rate is about 34 to 35 % of our GDP with an investment rate of 36 to 37 %. And with a capital output ratio of 4:1 we can manage to have a growth rate of 9%.

On the face of it, this is a reasonable statement. Savings do translate into investment closely enough (give or take foreign direct investment, cash stuffed under the mattress, etc.), and accumulated capital in the form of investment aids in future output growth. And, at any point in time, one can compute the ratio between capital and output as a ratio. That’s all true enough.

What’s disturbing is the manner in which Manmohan Singh apparently relies on the crutch of capital/output as a solid parameter to be manipulable by policy. This has been a consistent factor in his economic thinking for quite some time, and goes back to the assumptions of early Indian planners that the accumulation of capital alone would suffice for growth.

Well that wasn’t necessarily true in Nehru’s time and it's not true now. For instance, note as Yasheng Huang does that China is far less effective than India at translating savings into growth (the country also saves more in general). So this is not some fixed parameter set by immutable laws. Instead the capital/output ratio is highly responsive to the general policy environment and incentives faced by economic actors. In China, presumably what you have going on is a lower degree of allocative efficiency. Yet one might equally have concerns in the Indian context about the role of policy; with microeconomic problems of labor quality, health, land acquisition, general governance, labor laws, taxation, and so on and so forth. It is exactly in order to evade the government’s abysmal failure to tackle these existing and tangible problems that Manmohan Singh suggests that the problem of growth can be reduced to an arithmetic question of savings and investment. Yet that relationship may not hold up in the absence of additional reforms to improve governance and tackle the various other binding constraints that hold back growth. (oh, to be sure he mentions other steps to make sure this will happen; but if his proposals haven't taken off in the last seven years why would they take effect now?).

Let me put it this way — Tim Pawlenty recently received a lot of flack for suggesting that his economic policy would simply demand 5% growth for a decade. What if he had said instead; “I will push savings up to 20%; then since there is a 4:1 relationship between investment and growth we can expect 5% growth.” I think most people would find the idea a little nuts. Many misadventures in development economics have included failures where simply pumping in more capital didn't necessarily get you more growth in an arithmetic fashion. The root problem is that any current relationship between savings and growth doesn’t represent a causal relationship manipulable by policymakers. That’s the Lucas Critique in action.

Mortgage Modification and Strategic Behavior

2011-06-29T16:03:00.000-07:00

I have a co-authored paper with Chris Mayer, Ed Morrison, and Tomasz Piskorski that is live on NBER:

We investigate whether homeowners respond strategically to news of mortgage modification programs. We exploit plausibly exogenous variation in modification policy induced by U.S. state government lawsuits against Countrywide Financial Corporation, which agreed to offer modifications to seriously delinquent borrowers with subprime mortgages throughout the country. Using a difference-in-difference framework, we find that Countrywide’s relative delinquency rate increased thirteen percent per month immediately after the program’s announcement. The borrowers whose estimated default rates increased the most in response to the program were those who appear to have been the least likely to default otherwise, including those with substantial liquidity available through credit cards and relatively low combined loan-to-value ratios. These results suggest that strategic behavior should be an important consideration in designing mortgage modification programs.

Adam Levitin has weighed in here, and David Henderson has done so here.

The Value of Marginal Education

2011-06-27T10:10:00.000-07:00

There’s an ongoing debate at EconLog, Marginal Revolution, the New York Times and elsewhere over the value of additional education. No one doubts that education appears to be a valuable investment for students who pursue it. But it valuable for the marginal individual? Do we need public policy to steer more students through high school, College, and degrees beyond? Given the centrality of cognitive ability and human capital to economic output and general wellbeing, this has to rank as one of the more important economic questions out there.

Tyler Cowen refers us to some studies:

How much do returns to education differ across different natural experiment methods? To test this, we estimate the rate of return to schooling in Australia using two different instruments for schooling: month of birth and changes in compulsory schooling laws. With annual pre-tax income as our measure of income, we find that the naıve ordinary least squares (OLS) returns to an additional year of schooling is 13%. The month of birth IV approach gives an 8% rate of return to schooling, while using changes in compulsory schooling laws as an IV produces a 12% rate of return. We then compare our results with a third natural experiment: studies of Australian twins that have been conducted by other researchers. While these studies have tended to estimate a lower return to education than ours, we believe that this is primarily due to the better measurement of income and schooling in our data set. Australian twins studies are consistent with our findings insofar as they find little evidence of ability bias in the OLS rate of return to schooling. Together, the estimates suggest that between one-tenth and two-fifths of the OLS return to schooling is due to ability bias. The rate of return to education in Australia, corrected for ability bias, is around 10%, which is similar to the rate in Britain, Canada, the Netherlands, Norway and the United States.

These are all basically examples of an Instrumental Variable (IV) approach. Let’s take these one at a time. First, we have the month of birth evidence. Yet this is the classic example of a weak instrument, an issue which is well discussed elsewhere. The month or quarter of birth has a very weak impact on final educational outcomes, and parents with children born in different months are not identical either.

Next, there is the compulsory schooling evidence, that Arnold Kling actually takes on as well, though only in the US context. He observes that the variation across states in terms of when a student can legally graduate doesn’t seem to predict their actual graduation habits. This is basically also a weak instrument; at least in the case of the US.

Finally, we have the twins evidence. The idea here is to observe one twin going to College and compare her with her sister twin who did not go to College. The assumption is that these two individuals shared identical environmental background factors, and so any resulting differences can be causally attributed to the College attendance of one twin. While this is a clever trick, it requires you to believe that twins are interchangeable humans. What if a family can only afford to send one twin to College, and so they send their more able child? What about all sorts of cognitive and non-cognitive differences that come up between children growing up in the same house? What about the possibility of twin interactions? Though interesting and suggestive, I don’t believe this evidence to be causally definitive.

It’s easy enough to knock holes in any body of literature, even one (as here) which does purport to establish identification. So here’s some evidence that points in the other direction.

1. Cognitive abilities have limited scope for educational intervention in developed economies beyond age ~5.

The evidence of this actually comes from James Heckman. He argues that we simply do not have access to any educational treatment that can reliably boost IQ over an extended period of time. Even the lauded Head Start/Perry Preschool programs can't do that. And if spending tens of thousands of dollars per pupil on a pilot program can’t produce results, it’s difficult to imagine what would.

An education proponent could now say something like, “Fine, but cognitive skills aren’t everything. Heckman supports Head Start — because it boosts noncognitive skills like impulse control.” Suppose I even grant that point — though I note that these noncognitive skills are something like a black box. There’s defined entirely as a residual of what can’t be a cognitive skill, and are inferred largely on the basis of lower crime rates among treated populations.

But think about what that would mean. Everything we do in schools — the teaching, the homework, etc. — has limited value when it comes to actually improving mental functions. Rather, it may or may not be effective in domesticating children to functioning in a modern post-industrial economy. At the very least, that would suggest that education ought radically change its focus away from cognitive tasks towards those aspects of behavior modification. Maybe we’d get the same results as school from a program forcing children to dig holes every day and fill them back up. Also note that Heckman’s results on the payoffs of education based on these noncognitive skills is rapidly declining in age. Are Head Start, prenatal care, or child nutrition policies worthwhile? Very likely. What about pushing unprepared children to attend College? Less clear.

2. Other estimates of the marginal return to education are low.

Heckman has another paper with coauthors where he attempts more rigorously to estimate the marginal impact of more education — in particular, of more College. Even the Instrumental Variable estimates discussed above may be biased — as they measure the impact on individuals induced to have the treatment (ie, more education). This need not be the same population as those induced to have more education in response to some arbitrary policy change.

Instead, Heckman creates an estimate designed to get exactly at the impact of more College on outcomes. The basic logic of his approach is to find individuals who had a low ex ante likelihood of attending College, but who went anyway. These are a proxy of the individuals targeted by, say, a program to induce more people to attend College.

He argues:

For a sample of white males from the NLSY, we establish that marginal expansions in college attendance attract students with lower returns than those enjoyed by persons currently attending college. The contrast between what conventional IV measures and the marginal return to a policy can be stark. For example, while the conventional IV estimate is 0.0951, the estimated marginal return to a policy that expands each individual’s probability of attending college by the same proportion is only 0.0148. This policy induces students who should not attend college to attend it. Too many people go to college. [Emphasis added]

Note in particular that his estimates are consistent with high “IV” estimates — based on a set of instruments that he was able to use here. So even if the “identified” estimates based on the IV literature are correct, they do not necessarily serve as useful diagnostics on whether College expansion programs are worthwhile.

I’ll acknowledge that there’s substantial uncertainty about this question and much that we don’t know. I’m not particularly on one “side” in this debate. But this is such a difficult question to answer because people who seek more education would likely have done well anyway.

What I can say is that the most effective policy interventions here have little to do with simply broadening the access to education. All sorts of early child intervention techniques seem to yield positive results. A number of charter school/school choice/voucher experiments have resulted in institutional improvements in the quality of education while lowering the cost.

Right-Wing Keynesianism

2011-06-26T22:32:00.000-07:00

There's an idea going around to offer a one-time tax holiday to multinational firms to encourage them to repatriate income. The US, somewhat absurdly, charges multinational firms domestic tax rates on income earned in other countries. This encourages companies to re-invest foreign profits overseas rather than repatriate that income domestically -- unless they receive a special tax break to do so.

The clear solution to this problem would be to move over to a territoriality-based tax system in which all taxes are levied depending on the tax rates prevailing in the country where the business is taking place. This would simplify the tax code; remove absurd barriers to capital returning home; and generally move to a globally harmonized system of corporate taxation.

A one-off exemption is a second-best attempt to deal with this problem. This poses a number of different problems -- in particular, businesses come to see these one-off exemptions as inevitable, and so stop repatriating profits in all other periods. This ends up "heightening the contradictions" in the corporate tax system, as it were, and ensures that exemptions become regularized.

The other chief complaint is that repatriated corporate profits don't go to productive purposes. This is the claim from Howard Gleckman at the Tax Policy center, who draws on research in the field. The paper he references finds that repatriated profits were largely dispersed to shareholders.

Here's the thing though -- those shareholders then went and did something with that money. Perhaps they reinvested in company shares; maybe they went and bought a yacht. In the case of your left-wing Keynesianism, you issue a bond for a dollar and then spend that dollar on some sector of the economy. That may not logically preclude an economic expansion, but you can see what the difficulty is. But in the case of this right-wing Keynesian policy; you do have a genuine influx of foreign cash into the economy. Perhaps corporations aren't the ones spending the money. But someone sure gets that money and spends it. To be sure, there is a parallel problem that a large enough capital influx will adjust exchange rates however.

In general; I'm increasingly skeptical of tests like the one in the paper I mentioned, where you have a specific experiment applied to some subgroup of the population and you try to learn about the response. Even if you get the identification right (and that paper spends a lot of time arguing that they have some); it's just difficult to extrapolate from there to think about what that might mean for an economy as a whole.

That makes me think this right-wing Keynesianism may be underrated. Moving to a better tax system is a win; and shifting cash domestically in the short-run may be a win too.

Asset Prices, the Business Cycle, and Unemployment

2011-06-25T17:15:00.000-07:00

A few months ago, I blogged about research done by Roger Farmer and Naryana Kocherlakota on understanding unemployment; and in particular relating trends in unemployment to asset markets and investor confidence.

The key issue is that it's difficult to understand why unemployment remains so high so far after the financial crisis. A real business cycle approach would look for real shocks to production; in particular idiosyncratic shocks to technology. Yet it appears that this recession involves a number of nominal and financial-sector related frictions difficult to rationalize using that model.

Another approach relies on New Keynesian thinking. In this view, prices are “sticky” as it is costly to adjust prices in the short-run in response to a moderate shock. This induces a friction in in economic activity, especially in the market for labor, that can be fixed through macroeconomic stabilization in the form of monetary or fiscal stimulus. However, if you look at scanner data, retail prices are actually fairly flexible. On top of that, the economy faced such a substantial shock, and we are sufficiently far out in the future, that surely price-setters have had the chance to adjust prices by now.

In short: the particular frictions and shocks underlying traditional macroeconomic models seem to be of limited relevance in explaining this recession. As a result, I’ve been trying to read up on alternate models — relying, for instance, on financial market frictions, household balance sheets, etc. Roger Farmer, in a new paper, offers up another such model that relies on old-style Keynesian thinking.

The basic logic comes out in this graph:

This shows asset prices and unemployment being closely linked throughout the business cycle; which isn’t a trivial fact. The logic is that asset prices follow bubbles and crashes due to self-fulfilling optimism and pessimism from investors. These booms and crashes result in larger social consequences in the form of higher unemployment through search frictions in the labor market.

In this model — as in some sense as in Keynes original work — investors do have rational expectations. They expect a bubble; and a bubble happens. They expect an economy that performs poorly over an extended period of time; and that too materializes.

Nevertheless, the paper still relies heavily on psychological assumptions about investor behavior. Investor confidence drives both asset prices, as well as willingness to hire. This response is, as I suggested in my last post, asymmetrical, as it is harder to hire than it is to fire.

I find this paper interesting as it brings the problem of unemployment into the domain of asset pricing. While Farmer emphasizes the psychological basis of bubbles and busts, someone like John Cochrane would emphasize how ultimately discount rates — the rates at which we value future income relative to current income — determine the values of current financial assets (which are just claims to future cash flows).

In Cochrane’s world — asset prices fluctuate in conjunction with macroeconomic outcomes. Is the economy looking bad? Do you anticipate losing your job, your business, or other such negative shock? If so, you wish to hold less risky assets. Yet we can’t all rebalance away from risk, as there are only so many stocks and bonds and so forth. Instead, the price of stocks and bonds fall in order to compensate us for bearing this sort of risk in a time of economic uncertainty.

Yet Farmer would point out that the process also works in reverse. High discount rates — equivalently, “pessimism” — felt by the owners of capital manifest themselves in an unwillingness to hire, particularly if there are frictions in the labor search process.

I suspect that tying Farmer’s model into a more "rational" model of asset prices that emphasizes the links between financial markets and real markets would amplify the multiple equilibrium nature of unemployment. This was the key feature of Keynes of course, and it’s interesting to see Farmer resuscitate this idea. And with unemployment at 9% or what have you it doesn’t seem implausible to think that numerous economic possibilities are open to us, depending on the nature of economic equilibria we end up at.

Gurgaon is the Cyberpunk Utopia

2011-06-12T22:24:00.000-07:00

The New York Times has a dystopian article on the burgeoning Indian city of Gurgaon. Alex Tabarrok rebuts with partial defense of the city, and I want to go much, much further.

To understand Gurgaon, you need to place in context with two failed modernist models for which it serves as a foil — Le Corbusier's Chandigarh, and Lutyens' Delhi.

Chandigarh is on the opposite side of the state of Haryana from Gurgaon, and is in many ways its complete antithesis. As it happens, there is also where I was born. The city was conceived by Jawaharlal Nehru as a future Administrative capital that would embody his rationalist, secular, modernist vision for an independent India. The city was largely designed by Le Corbusier, who had an overlapping modernist vision, and was fortunately unable to inflict this dream on too many other countries. Here is James Scott on the city in his Seeing Like a State:

Whereas road crossings in India had typically served as public
gathering places, Le Corbusier shifted the scale and arranged the zoning in order to prevent animated street scenes from developing. Notes one recent observer: "On the ground, the scale is so large and the width between meeting streets so great that one sees nothing but vast stretches of concrete paving with a few lone figures here and there. The small-scale street trader, the hawker or the rehris (barrows) have been banned from the city center, so that even where sources of interest and activity could be included, if only to reduce the concreted barrenness and authority of the chowk, these are not utilized."

As he goes on to detail, Le Corbusier built the sort of city Times readers might prefer to read about at a distance -- one with large boulevards and carefully planned and segregated townships. Yet this city is sterile, non-diverse, and in a certain sense unlivable.

Luytens' Delhi, too, was a forceful stamp of an alien vision on India. Designed as the center of the British Raj, it was rapidly appropriated as the center of the bureaucratic, license raj India.

Gurgaon came into existence, in a concrete and visceral sense, as the rejection of these modernist aspirations. Though near Delhi (and connected by a privatized highway), it is in the state of Haryana — and so did not suffer from the regulatory and tax impediments of the national capital. Its growth has taken place in reverse proportion to the stultifying effects of India's regulatory regime, which was partially dismantled starting in 1991.

Unlike the commercially and socially bleak Chandigarh, Gurgaon rapidly became a dynamic hub, home to both large industrial plants as well a torrent of service industries in fields ranging from IT to financial services to real estate. The local mall culture, though sneered at by the mandarins of Luytens' Delhi, reflects the consumerist aspirations of a new generation, while the nightlife is booming as well. Both Chandigarh and Gurgaon rank among the top three richest cities in India; yet Chandigarh derives much of its wealth from the income of bureaucrats. Gurgaon’s wealth is all privately generated.

Despite these substantial achievements, many people — even in India — react to Gurgaon with disdain. On paper or in a photo, Gurgaon is a messy place. This sense of disorder manifests itself most literally in the realm of unorganized and intermingled uses of property. When seen in a picture by those conditioned to "see like a state," this appears haphazard and disturbing. Surely, some state entity must come in and clean that up, and return us to an orderly world of happily segregated functions. Yet the form of such economically integrated units, though perhaps not visually appealing to an eye conditioned by Leviathan, are in fact most conducive to the functions of economic and social fulfillment, and are partially why immigrants flock to the city. There is a hidden internal logic here. Jane Jacobs would have hated Chandigarh, and perhaps come to love, or at least appreciate, Gurgaon.

Gurgaon tends to be lowly ranked on indices of where people would like to live based on “objective” criteria; yet regularly tops surveys of where people actually say they want to live. Surely the collective decisions of 1.5 million people count for more than the editorial decisions of magazines or the fleeting judgments of parachuting foreign journalists. Rather than asking Gurgaon to conform to your aesthetics; shift your aesthetics to accommodate Gurgaon.

Yet Gurgaon will handle just fine the concerns of well-intentioned leftist bloggers. It is wealthy and powerful enough to constitute a power center of its own, and various other public goods will come into the city soon enough through political pressure (the Delhi metro, for instance, is being extended there). Somehow, the city seems to have given everybody access to electricity, which is a challenge in other parts of India where the state is marginally more present.

More at risk are politically vulnerable slums. Like unplanned Gurgaon, the state sees these entities as blemishes on the earth to be destroyed. Dharavi for instance is a well-known slum in the heart of Mumbai, and is routinely at risk of destruction in resettlement plans.

What city planners rarely realize is that such slums, just as much as Gurgaon, reflect exciting engines of opportunity and capitalism. New York for instance has long been home to large centers of industry — the meatpacking district for instance. The advantages of density and transportation offer huge advantages for a number of industries; and indeed Dharavi is something of the commercial hub of Mumbai, home to thousands of business, tens of thousands of factories, while being the recycling center of the city. India has actually struggled to translate booming economic growth into employment gains — unlike in China, onerous labor laws have limited large-scale manufacturing employment. However, areas like Gurgaon and Dharavi, in their own ways, are the employment hotspots of the country.

They are also inclusive of newcomers. Millions of Indians hope to transition from a life of subsistence farming to something better. Yet regulatory restrictions on urban land, paired with city slicker xenophobia about foreign migrants, make this difficult. Only in Dharavi are there cheap enough rents and an inclusive enough attitude to absorb migrants, many of whom sojourn through the place over time to something a little nicer. Various redevelopment plans in motion would completely destroy this social fabric. Even if families receive comparable housing plots, the networked system of small industrial plants would be completely destroyed, and a valuable form of commercial growth would disappear. For more on this, see this Tedx talk by Matias Echanove and Rahul Srivastava. They point to pictures like this:

The left half of the picture is Dharavi; the right half is Tokyo. The reason they seem to blend right in is that well-situated historical cities like Tokyo tend to build organically up from their underlying source, rather than relying solely on state initiatives to place things in nice grids or dismantle everything in favor of high rises.

Areas like Dharavi and Gurgaon also represent one of India’s few strong areas of economic comparative advantages relative to China, a country with an economy three times as large. China's mega cities are actually relatively smaller than one might expect for a country of its level of development and urbanization — a legacy of controlled migration into urban areas. By contrast, India’s greater Delhi — including the capital region plus satellite cities like Gurgaon — has over 22 million people. This mass density and agglomeration of individuals facilitates a far greater degree of specialization and interaction, something that economics from Adam Smith on down have placed at the heart of economic growth.

To be sure, Gurgaon and Dharavi have real prolbems. But too frequently, urban developers use these problems as excuses to implement overweaning solutions that destroy local social capital, networks of economic activity, and the decentralized tricks that people come up with to solve local solutions. More Chandigarhs, Brasilias, or project housing aren't the way to handle urban problems. Just let these cities be and they'll surprise you.

Unemployment and Recalculation

2011-06-12T22:19:00.000-07:00

There are two ways to think about current deep and persistent rates of unemployment. One point of view is that these merely reflect the poor rate of economic growth, and ought be remedied by stimulus either fiscal or monetary. Another point of view is that high unemployment reflects the degree of economic restructuring that needs to happen to cover the malinvestment of the housing boom; and so easy fixes are not available for the labor market. The first set of views are held by a number of people across the right and left; with the preference for fiscal/monetary stimulus varying by ideology. The second set of views are held by a motley of individuals, from Austrians to Raghuram Rajan, to Minnesota Fed President Narayana Kocherlakota, to Arnold Kling and his idea of PSST (patterns of sustainable specialization and trade).

One point of evidence in favor of the “structural” view is the pattern of hiring and firing — in which many jobs across a range of dying industries are disappearing. According to that school of thought, this indicates that those industries are experiencing a reallocative shock.

Ricardo Caballero comments on this in an interview with the Minnesota Fed:

Q: And should we be concerned about jobless recovery in the United States? Do you think there might now be a higher level of structural unemployment?

This was a time when the important work of Steve Davis and John Haltiwanger in documenting the nature of the process of job creation and destruction in U.S. manufacturing led to an explosion of research trying to explain this process.

One of the key features of their findings was that recessions come with sharp spikes in job destruction. Somehow, other researchers jumped to the conclusion that this spike meant that job reallocation was strongly countercyclical. That is, that reallocation increased during recessions: a sort of Schumpeterian cleansing. Many theories were written about this phenomenon.

Mohamad and I made the rather obvious observation that a spike in destruction in itself does not mean that reallocation increases during recessions, since this would also require that creation increases. Steve and John had already documented that job creation actually falls at impact. We explored whether the initial spike in destruction translated into abnormally high creation during the recovery phase of the cycle, which would be a dynamic version of the countercyclical reallocation story. Not only did we not find this increase in creation during the recovery, but we found that job creation was actually below normal levels. That is, cumulative restructuring is procyclical, not countercyclical.

We then went on to show that a model where financial constraints tighten as a result of the recession could explain such patterns. I think this is the connection with the current recovery. This was a recession which severely damaged the financial sector; hence, it is not surprising that hiring is so muted.

I don’t think this view is inconsistent with the idea that the economy does face long-term structural challenges in adapting to new social and technological changes. However, I’d say it tackles the idea that such reallocative challenges are an argument for weaker stimulative efforts. Rather, this seems to say that proper economic recovery goes hand in hand with reallocation. No need to view AD/PSST as opposed from the policy point of view.

For More Corporate Raiders

2011-05-27T08:28:00.000-07:00

There’s welcome news that a hedge fund operator - David Einhorn - has bought up large chunks of Microsoft with the intent of forcing the ouster of the CEO Steve Ballmer, presumably replaced with a CEO more responsive to shareholder interest. The end goal is a more productive use for Microsoft’s capital.

I think this is great news. The key here is that the interests of Microsoft’s CEO and the interests of Microsoft’s shareholders are different; and we as a society ought to sympathize more with the interests of Microsoft’s shareholders.

Basically, Microsoft has been earning monopoly rents based on intellectual property that locks in network advantages. Yet Microsoft’s comparative advantages really extend only to the sort of monopolistic domination embodied in their control of OS and enterprise software. Their subsequent ventures in all other areas — Bing, the Zune, .Net, etc. — have on net been catastrophic failures that have cost the company billions of dollars. Microsoft persists as it’s in the interests of Microsoft executives to control as much market; not to deploy capital efficiently.

And not just Microsoft — as various other companies figure out how to market durable brand advantages in tech, other companies too are generating massive profits. Some of these companies, like Amazon, have figured out how to re-invest their profits in new fields to continue generating value in ways that enrich executives, shareholders, and consumers. IBM has transitioned away from hardware to software in a disciplined manner. Other companies, like Microsoft and Cisco, basically sat around burning money at each new trend. Just now, Microsoft decided to spent $8.5 billion on Skype for no good reason.

It's difficult to throw away this much money without having the occasional hit. The XBox wasn’t bad. But the collective impact of many companies simultaneously burning money is substantially weaker economy-wide capital allocation. We don’t want the people who made a lot of money in the ‘90s deciding what to invest in today; in general people and organizations don’t manage to remain at the entrepreneurial frontier all of the time. We want shareholders to take the billions they made from Microsoft and give it to the Microsoft of tomorrow. And that’s just not possible as long as Microsoft remains hideously mismanaged from the point of view of intelligently handling shareholder interests -- as long as they can neither reinvest assets profitably or have the good sense to give money back to the owners of the company.

This isn’t just an issue for a handful of hedge funds — Microsoft has a market cap in excess of $200 billion, and so must of us collectively own a part of the company via a 401(k) or whatnot.

Yet while activist hedge funds and private equity firms have the ability to take on companies like this in a number of fields -- their actions remain constrained. As Amar Bhidé noted in A Call For Judgement, securities laws have severely restrict concentrated ownership and shareholder management. This problem seems to be particularly severe among financial companies -- the one place you'd like to see more institutional investors, say, call for Dick Fuld's ouster.

Energy Prices

2011-05-23T22:34:00.000-07:00

Matt Rognile is blogging again, and has a post up on how the federal government ought to provide some sort of insurance against the cost of rising gas prices.

I’m sympathetic to this sort of thinking. I think it’s clear that a large part of what motivates hard money advocates is the fact that constant energy fluctuations leave an immediate impact on the purchasing power of families. Raj Chetty, someone who I seem to cite all of the time, has emphasized the role of commitment goods (like mortgage or auto payments) in reducing the discretionary income available for families. Fluctuations in the price of an essential good can hurt families tremendously, even if the actual price or consumption impact is small in relative terms, especially if families are credit constrained.

Meanwhile, to the extent that energy fluctuations signal permanently higher prices, they also induce structural changes in the household demand for items like energy saving cars. Yet, again due to credit constraints, households may be unable to adjust their assets — while the higher immediate cost of making gas payments may actually make it harder for them to change cars.
A recent paper by Nick Souleles and co-authors have some evidence suggesting that the Bush economic stimulus payments in 2008 ended up performing exactly this insurance role. Aside from delivering payments around the worst time of the oil shock — these payments (roughly $300-1200 ) also relieved a collateral constraint for many families. Their evidence suggests that many families used the money as down payments for more gas-efficient cars. Jonathan Levin's research (in part, what has won him a John BatesClark Medal) suggests that amounts of this size can indeed serve as down payments for subprime auto loans.

On top of the household benefits of hedging against an unexpected rise in prices for constrained households, there are the larger effects of oil shocks. Increasing durable consumption right at this time may have helped auto companies avoid even worse losses. Also, there's the issue that gas prices make macroeconomic stabilization much more difficult. A large part of this last recession was attributable to high gas prices, while a persistent oil deficit worsens the current account deficit. In classical theory, that isn’t so worrisome by itself, as a current account deficit will eventually be balanced out by higher future exports or capital inflows.

But high capital inflows can be very dangerous. In general, they tend to be associated with asset price appreciation, and a skew in domestic prices away from (increasingly uncompetitive) tradable goods and towards durable, non-tradable goods (like housing and real estate). This has been a contributing factor behind the Asian crisis, and may have been a large factor behind the most recent crisis.

However, despite bemoaning this state of affairs, the Fed has decided to do very little about this. Bernanke’s research has pointed to the need to respond to an energy shock by loosening policy; yet the dictates of an inflationary target would demand a contractionary response just as the economy is reeling from the effects of higher oil prices. His paper in fact found that energy shocks are contractionary exactly in part due to a misguided monetary shock. This debate is basically going on now, as higher oil prices driven by global factors are hurting the economy; yet are used by hard money advocates as evidence that easing has gone too far.

Bernanke has also complained about the impact of a global “supply glut” that led to large capital inflows, and fueled the demand for structural financial products that could offer seemingly high rates of return at low cost. Yet he hasn’t taken the next step of thinking through (publicly) how the US should respond. Some set of measures imposing capital controls or active management of foreign reserves to target international currency rates would affect net financial flows. Yet these ideas, while implemented routinely in the world’s central banks, remain verbotten at the Fed. This sort of stuff is the job of the Treasury, which has no tools to implement any of these targets, and in any case is mostly interested in obtaining as low interest rates for federal debt as possible.

However, even without trying out capital controls, simply lowering the level of imports of oil would have an enormous effect on current accounts deficit, and so on the degree of net capital inflows that result. As Calculated Risk always points out, America would be much closer to trade balance excluding the impact of oil.

America's dependence on oil is bad. It's bad for households and it's bad for the economy. It's not crazy to think about ways to move away from oil, both to avoid the impact of transitory shocks, as well as the costs of long-term dependance.

Were Mellon and Hoover Liquidationists?

2011-05-15T17:27:00.000-07:00

Josh Green's profile in The Atlantic of Ron Paul contains this section on interpreting Great Depression era policies:

The Austrian school had peaked in the early 20th century but had fallen away after the Great Depression, which it claimed was caused by an expansion of the money supply and could be met only with chastened submission as the market corrected itself. Herbert Hoover’s Treasury secretary, Andrew Mellon, offered similar counsel, famously urging Hoover to “liquidate” and “purge the rottenness out of the system.” But this failed to stop the catastrophe. Only when Roosevelt took the dollar off the gold standard and committed to deficit spending, and the Fed adopted consistently low interest rates, did the economy finally start to recover. This validated the argument of the Austrians’ intellectual adversaries, economists like John Maynard Keynes, that rather than stand aside, governments should intervene to mitigate recessions.

The idea that Mellon advocated "liquidation," and that the adherence to this strategy were among the major contributors to the depth of the Great Depression are widely held views. However, they are simply not true, as Lawrence White explains.

First, the quotations attributed to Mellon in fact come from Hoover's own autobiography. Here's what Hoover had to say:

First was the “leave it alone liquidationists” headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”

While apparently damning, White explains that this passage was primarily intended to highlight the differences between Mellon's views and those of Hoover. The "quotations" likely do not reflect Mellon's actual words, but are rather exaggerated for effect.

While Mellon recognized the need for painful readjustments, he was in reality not the extreme liquidationist portrayed either by Hoover or Josh Green. He supported successive interest rate cuts by the Federal Reserve, and tax cuts and spending measures by the Federal Government.

Nor did Hoover follow a liquidationist policy either. Rather, as his own autobiography and the historical record amply demonstrate the extent of his intervention in the economy. Deficit-fueled spending grew dramatically under his tenure. Among many other initiatives, Hoover's Reconstruction Finance Corporation lent billions to banks, states, and other firms.

In fact; it was Roosevelt who re-introduced fiscal balance by 1937-8. This period also saw dramatic monetary tightening by the Federal Reserve, a move convincingly linked to a recession that began at that point.

Though tempting to think of historical figures solely through a stark moral lens, the lessons of the 1930s are more complicated than commonly realized. Far from being a stark "liquidationist," both Hoover and Mellon worked to orchestrate dramatic federal interventions that nonetheless failed to secure recovery. More durable recovery happened under Roosevelt; but even under his tenure Federal Reserve officials erred badly in sharply contracting the money supply and plunging the country into a new downturn. Finally, federal interventions by both Hoover and Roosevelt that regulated prices and wages throughout the economy likely had negative effects on economic recovery.

While analyzing the beliefs of long-dead historical actors may be tedious, the depth and duration of the current crisis have brought increased relevance to the actions of Great Depression-era policymakers who faced similar problems. Their actions, real or perceived, continue to inform policy debates today. That's why it's important to set the record straight on their actual policies.

Are Democrats or Republicans better for the Economy?

2011-04-18T09:19:00.000-07:00

Larry Bartels has frequently argued that Democrat Presidents are better for the economy. Here's the takeaway graph:

Just observing a correlation between the partisan identity of a President and some economic outcome isn't the most convincing argument in the world. Jim Manzi and James Campbell present reasons to be skeptical that this is a causal relationship. Among the reasons to be skeptical are that the state of the economy drives political results (ie, reverse causation); and that it's difficult to imagine the exact mechanism driving this result. Presidents can't wave their arms and force a given result -- Congress passes laws. Yet you don't see this same relationship if you graph Congressional partisan identity against economic outcomes.

I've long thought that a better way to think about this would be to do an event study on the stock market before/after an election, using past polling data as a way to get a

sense of what the market was "expecting" before the final electoral outcome. Justin Wolfers and co-authors have a new paper arguing in favor of this strategy (with prediction markets instead of polls), which uses this question as a motivating example:

First, we show that in the 2004 U.S. Presidential election, candidate convergence did not occur, as predicted by Downs (1957) and many other models. Speciﬁcally, the stock market rose 2% in value on news of a Bush victory (over Kerry). Secondly, we show this diﬀerence of 2% between Republicans and Democrats has been remarkably consistent over time, appearing in an analysis of all elections between 1880 and 2004. This suggests that whatever the changes in party structure and policy issues over that period, Republicans have consistently been the party of capital, and Democrats the party of labor. Finally, we show that the stock market declined in response to the news of a Democratic victory in the Senate (and House) in 2006, suggesting that,contrary to conventional wisdom, markets do not prefer divided control of the legislature and executive to uniﬁed control of both branches. [emphasis added]

Aside from representing a more statistically sound way of figuring this question out, this result has the advantage of consistency. The Republican-Democrat difference does vary from election to election, but is at least typically in one direction. There is also consistency between the Congressional and Presidential outcomes here. Here's a sample graph:

To be sure, the exact mechanisms behind this result remain opaque. A differing partisan propensity to levy capital gains taxes could be enough. Nor do better stock markets settle the question of which party is uniformly "better" for the economy -- even if Republicans are better for company profits, they may also institute other policies that alter the income distribution. The authors suggest that this makes Democrats "the party of labor;" but it is at least possible that higher stock prices reflect a greater earnings potential for the economy, which could filter down to all workers.

But what is clear is that this approach is a million times better than interpreting a correlation for causation. It's also better than just looking at how the stock market behaved before/after an election, as this takes into account the prior expectation that a given President was going to be elected. With the growing reach of InTrade, this method could probably be used for all sorts of things--the impact of PPACA on health company profits, etc. The only caveat I have is that what the authors call "the predicted probablility from InTrade" probably can't be interpreted as easily as they suggest.

Bubbles and Unemployment

2011-04-03T17:46:00.000-07:00

There’s a lot of commentary going around on why unemployment has proved to be persistently high during the recovery. As Yglesias notes, this boils down to the question “Are recessions caused by asset price busts fundamentally different from recessions caused by central bank efforts to curb inflation?” Paul Krugman has a strong take on this:

Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down.

The idea that the precise conditions of this recession are different has implications for the favored policies of both the right and left. On the left, some folks believe that the notion of balance sheet recessions calls for more measures to tackle household negative equity, optimism for fiscal policy, and skepticism regarding monetary policy (say, Krugman). On the right, other people emphasize mismatch problems in the labor market and the role of structural forces behind unemployment. They are frequently skeptical of how fiscal policy can fix these problems (sometimes, also monetary policy). In general, there are widespread beliefs that some particular features of the crash have limited the scope for traditional macroeconomic stabilization policies.

Via Stephen Williamson, Minneapolis Fed President Narayana Kocherlakota has a new paper that goes into this issue. He draws on the Keynesian work of Roger Farmer, who shows this graph:

Farmer’s idea is that the rate of unemployment at any time is indeterminate due to problems in the labor search market. In the absence of markets for the search time of workers, price signals are not necessarily sent to match workers with the right jobs. Instead, the level of unemployment is determined by expectations of the strength of economic activity, which is proxied by stock market performance. One problem for this idea lies in explaining why unemployment has been slow to recover even as the stock market has recovered. Farmer writes,

This paradigm provides us with a new way to think about large recessions like the Great Depression and the Great Recession of 2007—2009. Using the model from this paper I would argue that the world economy in 2008 was headed rapidly towards a high unemployment, low wealth, equilibrium. The move to this bad equilibrium was triggered by a loss of conﬁdence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets led to an ampliﬁcation of the crisis as panic hit the global ﬁnancial markets.

In the winter of 2011, the US labor market had still not recovered. I believe that much of the problem is connected with a lack of conﬁdence bylobal investors who are concerned with the possibility of a further collapse. Even though the US stock market may be appropriately valued based on historical price earnings ratios — market participants are concerned that the value of stocks could fall further. Variations in the level of conﬁdence are manifested in changing risk premia that are fully rational given the unpredictable behavior of future traders in the asset markets.

I find this argument more persuasive in explaining the employment dowturn than the failure of employment to recover; but it is easy to imagine alternate models in which employment growth is asymmetric with respect to the business cycle.

Kocherlakota's innovation is to bring this unemployment picture into a broader model involving bubbles and monetary policy. While his model is fairly complex, the end result is simple — as with Farmer’s model, the level of unemployment is ultimately determined not by prevailing wages, but rather by the amount of aggregate demand. The collapse of an asset bubble results in a substantial drop in demand, and will result in a hike in unemployment unless the central bank proves sufficiently accommodative in lowering nominal interest rates.

One way to think about this is to compare the stock market bust in 2000 with the housing bust in 2008. In both cases, you have an asset that drops dramatically in value (tech companies, housing) that results in large drops in comparable financial securities (tech stocks, mortgage-backed securities). The total wealth loss in the economy was roughly comparable between the two cases. Yet for the 2000 crash, the Fed was able to lean against the drop by moving conventional monetary policy enough. In the second case, the Fed quickly hit the short-term nominal interest rate barrier of 0, and was unable to ease further though conventional channels. It did pursue unconventional policies like QE2, but was hesitant to do so and faced unprecedented levels of backlash for the easing that they did happen.

So, one way to read Kocherlakota is the following: given that monetary policy-induced demand fixes the rate of unemployment, recovery difficulties now reduce to the fact that the Fed has been insufficiently accommodating as the some interest rates hit the zero-rate bound. If the Fed instead proved more willing to consider unorthodox policies like quantitative easing or currency depreciation, we could have whatever degree of unemployment we liked.

The ultimate origin of a recession, in this model, is completely irrelevant to the possibility for the recovery. Issues with debt overhangs, structural unemployment, etc. are all second order effects relative to the fact that Fed-induced nominal spending has lagged; and the optimal recipe is not fiscal stimulus, but further Fed-based easing. Recessions caused by asset-bubble bursts do not differ from the garden variety recession, as long as the Fed is in fact appropriately accommodating.

So, the real issue is not that bubble-induced recessions are diffrerent in some way, but rather that policymakers respond to them differently. Rather than saying “the recovery in the 80s was quick because it was a Fed induced recession”; the issue instead is that the Fed had more scope to tackle that recession than this one.

Is Industrial Policy a good idea?

2011-03-23T22:02:00.000-07:00

Industrial Policy is back—or so Dani Rodrik proclaims. Several European countries openly advocate the government promotion of particular industries, while the World Bank’s chief economist now supports industrial policy for developing economies. America, too, is flirting with increased government intervention in firms, through various green initiatives.
Yet the debate over industrial policy remains simplistic. Advocates frequently point to countries that support industrial policy—such as China or France—and observe that these countries are rich or growing. Industrial Policy is presumed to be the cause of their growth, and it is pronounced a success.

There are many problems with this analysis. As William Easterly notes, it is important to get the comparison right. France might be doing even better if its firms had less state interference. A better analysis would examine all countries that try industrial policy—including the failures—and examine their relative success.

There are also a variety of non-GDP related costs associated with Industrial Policy that are difficult to nail down. To see this clearly: take the contrasting story of cell phones in India and China.

In India, the telecommunication sector shows the success of privatization. As long as a state-run firm handled phones, few people had landline access. Auctions of telecom licenses led to this huge burst of investment and innovation. The so-called “Indian Model,” that resulted delivered the world’s lowest cell phone prices and the mass adoption of cell phone services.
By contrast, China’s telecom policy has been based on the idea of getting state control over the commanding heights of telecommunications. Companies like China Mobile dominate cell phone services, while companies like Huawei are growing giants in telecom hardware. Judged from a pure economic standpoint, this type of state control is compatible with high rates of economic growth. These state-sponsored companies are also highly profitable.

But state control comes at a cost. China has higher cell phone rates, and texting is more popular partially as a result. International corporate acquisitions are also affected. India’s Bharti—a top private mobile operator—has purchased Zain, another private African mobile operator. Bharti plans on exporting its low-cost outsourcing model there, potentially revolutionizing African telecoms. State strategic interests, on the other hand, motivate China’s acquisitions. India’s competitive environment may be better geared towards generating internationally competitive firms.

The hidden costs of industrial policy may not show up on a simple economic ledger. But they are real nonetheless. If the past few years have shown private industry at its worst—think AIG or BP—it’s not clear that injecting more government control would produce better results.

Bankruptcy Reform and Financial Crises

2011-03-20T18:15:00.000-07:00

Mike Konczal has a fascinating idea that he expands in an interview: that the 2005 bankruptcy reform may have contributed to the severity of the financial crisis. The idea is that a change in the law expanded exemptions for derivatives during bankruptcy proceedings. This allowed derivative counterparties to end contracts and seize collateral as soon as bankruptcy was filed, moving to the head of the line among creditors.

There were several problems with this. First, this created incentives to restructure normal contracts, such as agreements to supply fuel to an airline company, in the form of swaps or derivatives. This was a win-win for creditors and debtors. Creditors were assured easy contract termination, even if the firm entered bankruptcy. Debtors were not generally required to post collateral for their contracts, allowing them to operate with a leaner capital structure.

Second, these rules expanded to define mortgage-backed securities as repos for the purposes of the safe harbor. This was potentially a huge change. Gary Gorton has argued that the demand for short-term securities, fulfilled by mortgage-backed securities, was fueled by the demand for information-insensitive, safe assets. Andrei Shleifer has suggested that these sorts of new, exotic securities were mispriced. While both of these may be a part of the story; there is another interpretation. The surge in securitization can be seen as a form of regulatory arbitrage designed to create short-term funding that would hold up in bankruptcy court. Without the penalty of potentially losing assets during bankruptcy, lenders were more willing to provide short-term funding to over-levered Investment Banks.

As Mike’s interlocutor points out: for non-bank institutions, this change was not the end of the world. Quick liquidation of existing contracts is akin to the Chapter 7 process (rather than the lengthy reorganization of Chapter 11). There are often advantages to slowing down the bankruptcy process, but small firms can be liquidated in an orderly manner.

The same is not true for banks. The special treatment of repos and derivatives in bankruptcy resulted in early termination and seizure of contracts by bank counterparties during moments of crisis or bankruptcy. The going-value of a bank—the excess value they have above and beyond the market value of its assets—is crucially dependent on its solvency and liquidity. Illiquid banks, by virtue of their leverage, are forced to sell their assets at fire sales, which can lower prices, which can lower the value of their assets further in a destructive spiral. Ensuring that certain forms of short-term funding and derivatives went to the front of the line in the Lehman case all but ensured that its bankruptcy would be a disaster.

The unintended systemic consequence of this treatment of bankruptcy was illustrated once before, during the failure of Long Term Capital Management. Intervention by the Federal Reserve happened precisely because regulators were worried that the failure of LTCM would cause a disorderly liquidation; a liquidation that would be worse exactly because derivative contracts could be terminated early.

As Mark Roe points out, the exemption that derivatives and repos enjoyed also warped their incentives to monitor the risk-taking going on at Investment Banks. The rule also possibly artificially increased the amount willing to be lent to banks, and gave them lower borrowing costs.

All of this points to a need to reform the bankruptcy code in order to treat derivatives on par with other claims. While legislative and popular pressure has focused on derivatives as being inherently bad, it would be better to fix legislation that encourages the over-use of derivative contracts and risk-taking; rather than leaving these elements in place, and hoping that other regulatory fixes elsewhere would solve the problem.

Revisionism on Deposit Insurance

2011-03-20T15:00:00.000-07:00

One of my personal pet peeves is the existence of Federal Deposit Insurance. Arnold Kling well characterizes the point of view I believe ("revisionist") against the standard position:

The standard view is that banking in a free market is inherently fragile, which makes deposit insurance necessary. In fact, some would argue that the concept of insurance needs to be extended to the so-called "shadow banking system." I think of Perry Mehrling and Gary Gorton as being in that camp.

The revisionist view is that deposit insurance is a case of the government concocting a solution to a problem that was created by government in the first place. That is, the U.S. banking system was unstable due to regulations that promoted small, local banks and inhibited the creation of diversified nationwide banks. Had banks been allowed to branch across state lines or had national bank holding companies been allowed to grow naturally, then (according to this argument) we would have seen few bank failures, even in the 1930's. Hence, there would be no need for deposit insurance.

There are several good reasons to argue against the traditional view that banking is naturally risky and therefore requires deposit insurance:

1. Maturity Mismatching is unnecessary. Japan, for instance, has historically adopted the view that lending of a certain type and duration should be matched with a liability similarly constructed. So instead of using flighty deposits to fund long-term projects, your deposits are funneled into assets with low risks and returns. Without crossing maturity lengths, the possibility of a bank run gets a lot smaller.

2. Absurd populist demands of the 19th century limited the number of branches a given bank could open. That resulted in a very geographically fragmented banking system prone to crisis every time agricultural yields fell in a given area. As a result, banks failed often and the entire business cycle was highly volatile.

Canada illustrates that the problem was exactly those banking restrictions, not banking in general. Canada's banking laws were far more permissive in terms of where banks could open branches, and the country developed a highly concentrated, well-regulated system of banks. By drawing on the deposits of an entire country, tiny shocks were not enough to force bank failure. In fact, the country barely experienced bank failures, and never saw banking panics -- even during the Great Depression. They did not even bother instituting deposit insurance until 1967. Canadian banks again outperformed American ones in the most recent crisis.

3. The past experience of deposit insurance before the 1930s was mixed. As Amar Bhide notes in A Call for Judgement, many of the state deposit plans performed quite badly through the Great Depression, frequently proving insufficient to cover all losses. The Indiana plan worked best by making other bank branches jointly responsible for the failure of a given bank. The national clearinghouse model also provided another vehicle for banks to collectively guarantee their deposits and prevent a panic, without requiring insurance. This sort of collective monitoring was not followed by other state plans, which performed poorly in sheltering depositors from bearing bank losses. Rather, by pushing some of costs of risky lending onto another party, they may have further encouraged bad lending and hastened banking crises.

The eventual adoption of FDIC insurance during the Great Depression drew on the disastrous experience of the standard issue insurance plans, as opposed to the successful mutual responsibility plans. It was was opposed by several interests -- including big banks, FDR, and the Treasury. Many of these actors were concerned by the poor performance of state insurance plans. However, federal insurance had the benefit of further entrenching the power of small banks, which would otherwise be a competitive disadvantage relative to their larger banking peers. We adopted the FDIC not as a part of a well-thought out plan to stem banking problems based on past evidence; but rather to satisfy the small bank lobby responsible for banking fragility in the first place.

4. The moral hazard aspects of deposit insurance have been tested internationally, and the results are fairly negative. A study by Aslι Demirgüç-Kunt and Edward J. Kane finds that countries with the highest coverage levels of deposit insurance are five times as likely to have a financial crisis as countries with low coverage limits. Better institutional quality (presumably leading to more prudential regulation) reduces the moral hazard caused by deposit insurance, but not entirely.

5. It's not clear that a banking crisis from one firm necessarily spreads to other, healthy, banks. The key test for this was the Great Depression, and my understanding is that studies point both ways on this.

At this point, FDIC insurance seems here to stay -- though it's worth pursuing policies to limit the amount of money covered by the insurance (say, at $100,000 per taxpayer, rather than $100,000 at each bank you have money at) or increasing bank co-insurance plans.

But this debate remains very relevant in thinking through the Shadow Banking crisis. One school of thought, best represented by Gary Gorton, feels that the problem there is similar to the issue in normal banking, and the solution lies in making repos -- the equivalent of deposits for Shadow Banks -- effectively riskless. Rather, the perspective above would point out the flaws in maturity mismatching generally, and would push against the institutional aspects of banking that make it more fragile by hiding risks and promoting moral hazard -- for instance, skewed salaries, the end of the partnership structure, and the bankruptcy treatment of derivatives.

Prometheus and Education

2011-03-14T16:45:00.000-07:00

Via Sanjoy Mahojan's excellent TED(ish) talk, here is a good quote:

The goal [of teaching] should be, not to implant in the student's mind every fact that the teacher knows now; but rather to implant a way of thinking that will enable the student, in the future, to learn in one year what the teacher learned in two years. Only in that way can we continue to advance from one generation to the next.
-Edwin T Jaynes

Yet this is a goal that's completely absent from any education reform movement of any flavor. Generally, the reformers try to change some aspect of schools or teachers in order to improve proficiency levels variously measured, ie smaller class sizes or merit pay.

What the quote illustrates is a broader point about education: that the process by which we teach must become efficient in time as we gain knowledge, or else our ability to advance the frontier of education necessarily slows down. Otherwise, people will take so long to advance to the frontier of knowledge that they have less time for active discovery, resulting in a Great Stagnation in research.

These teaching efficiencies have somehow happened anyway, at least in the math/science areas, without us being too aware of it. Calculus is now routinely taught in High Schools, while it was once at the frontier of knowledge. I'm not sure what advances in math education have allowed that to happen, but certainly students are being exposed to "deeper" knowledge at younger and younger ages.

I think this points to the importance of figuring out how to develop meta-cognitive tools that allow people to learn more in less time. ie, improvements in teaching pedagogy that really focus on reducing the actual time involved to learn a skill. I think this particular goal -- which aims for a steady reduction in the age at which students master given skills -- isn't really on the radar for any particular group, but it should be.

There are a couple of other creative ways to get at this idea. We can try more tracking-based systems, so children have more time to focus on learning in a particular direction. We can extend the hours that children spent learning, perhaps by using video games. Alternatively, we should be actively pruning the set of things taught in school as various forms of knowledge become less useful. Geometry and trigonometry seem to be widely taught, yet this is due largely to the importance of those tools to practical engineering applications in the 19th century, as well as reflecting the legacy of a particular mathematical tradition dating back to Euclid and beyond. Seems to me they ought be pruned to make way for mathematical tools of greater practical importance today, like statistics or street fighting math. In general, we should focus away from empirical facts (which are growing like kudzu) towards general reasoning; and in particular innovations that allow for rapid growth in the rate of general reasoning skills.

The Savings Glut

2011-03-10T21:20:00.000-08:00

I've ran into a few papers reinforcing the tie between global flows of capital, US monetary policy, and the financial crisis:

- This VoxEU article by Filipa Sa, Pascal Tobin, and Tomasz Wieladek argues that capital inflows, low interest rates, and a greater degree of domestic securitization were all linked to greater housing appreciation.

-Courtesy of David Beckworth, this paper by Rudiger Ahrend argues that persistently low interest rates are associated with larger rises in asset prices.

-Also by Beckworth, this paper by Thierry Bracke and Michael Fidora argues that monetary shocks, or liquidity, explain trends in global financial flows.

All in all, this seems increasingly damning for the Fed. Even if one accepts their excuse that foreign capital flows explain the whole issue, and that foreign preferences for savings and investment explain those flows -- that still would argue for some sort of action to curb capital flows.

Scott Winship and Inequality

2011-03-10T20:39:00.000-08:00

Scott Winship has a new post on inequality, arguing that the rising income share of the top 1% are replicated across a host of countries, suggesting that similar trends are driving growing inequality. This takes on arguments that, say, the demise of American unions is driving up incomes for the rich. If instead top earners are making more throughout the world, it seems more likely that some common technological or economic trend is driving that result. Here's his basic chart behind the idea:

This graph measures the share of income held by the top 1%, and the solid black line is America -- which is moving on trend with other countries.

This chart makes the following "correction" -- it assumes that the rise in reported American income after 1986 can be attributed to the 1986 Tax Reform Act, which sharply reduced marginal tax rates, and resulted in a sharp rise in self-reported income. Winship wants to interpret this result as a permanent shift in reported income. However, if you look between ~1983-1998, it looks like a fairly clean linear trend, with a temporary spike around 1986. There is also a small drop in reported labor income to evade the 1993 tax hike. It's possible that the 1986 tax reform only resulted in a transitory rise in reported income; certainly this is the argument in Piketty and Saez, where the US data comes from. Without that correction, the US becomes a slight outlier in terms of top income share.

Regardless, this data seem to support the idea that dynamics are very different within the Anglosphere and elsewhere. Canada, America, the UK, and Ireland all saw a sharply rising share of top 1% income in the past few decades. Countries like France, Germany, Sweden, and Japan also saw rising inequality, though not to the same degree. This points to winner-take-all dynamics operating within the large linguistic zone of English-speakers, as top talent moves smoothly between these countries. It's also notable that several of these countries have seen seen a comparatively greater role of Finance in recent years. From a paper by Reshef and Philippon:

It's telling that the drop and rise in relative wages in Finance mirrors the experience of top income inequality for the US as a whole. It's interesting to think through why the presence of the financial sector would alter income distributions for whole economies around the world. One explanation is that the role of leverage and arbitrage allows a select group of highly-skilled managers to concentrate a far greater share of income. Another possibility is that this reflects the role of opaque markets, information asymmetry, or some broader mispricing that is penalizing the real economy.

Another set of arguments this take on are those (ie, like that by Rajan) that argue for a causal role of income inequality in fueling the recent financial crisis. If instead inequality was broadly rising around the world, it becomes a more complicated story why the crisis began here.

Teacher Incentives Don't Work

2011-03-07T11:06:00.000-08:00

From Roland Fryer's new paper:

Financial incentives for teachers to increase student performance is an increasingly popular education policy around the world. This paper describes a school-based randomized trial in over two-hundred New York City public schools designed to better understand the impact of teacher incentives on student achievement. I find no evidence that teacher incentives increase student performance, attendance, or graduation, nor do I find any evidence that the incentives change student or teacher behavior. If anything, teacher incentives may decrease student achievement, especially in larger schools. The paper concludes with a speculative discussion of theories that may explain these stark results.

There really don't seem to be very many scalable ways to boost student performance at this point. Smaller class sizes or schools, early childhood education, even some school choice measures; all don't seem to improve test scores in a systematic way. Add to that now merit pay -- which, if anything, reduces scores.

If anything, this points to the edu-nihilist point that what goes in classrooms doesn't seem to impact what children know very much. Perhaps peer effects or family background are more important, or else variation across teachers just isn't very informative. One logical strategy in response to this information would be to forget about trying to raise test scores, and settle for providing schooling services at minimum cost.

Sticky Budgets and Inflation

2011-03-01T22:27:00.000-08:00

One of the benefits touted for having an inflation rate higher than 0% (but lower than, say, double-digit inflation) is that it corrects for the “sticky wages” problem. In some sense, we’d like to have wages vary by the business cycle. Workers should get paid more when times are good. When times are bad, workers should get paid less (rather than simply firing some workers, and keeping the rest at the same wages). However, for a variety of reasons, wages tend to stay sticky. So instead we allow inflation to happen. Then, by employers keeping wages constant during recessions, we can get some wage flexibility by diminishing the real purchasing power of labor (presumably, allowing capital to fire fewer of them).

But many other prices in an economy are also sticky — in particular, many forms of government spending. Here, for instance, is a graph of defense spending via Marginal Revolution:

Defense spending is an extreme example, but another way of stating this is that the government rarely cuts the dollar amount going to most programs. So if you want to cut back one program, or shift resources from one government department to another; that’s impossible.

What you can do is manage this tradeoff when prices in general are rising. Then, merely by capping the budgetary allocations for defense, you can cut real defense spending — this is what happened during the ‘90s. Another example of this principle comes from the recent Indian budget. This budget actually increased government spending, by 3.3%. However, in the context of rapidly rising domestic prices (resulting in rapidly rising tax revenue as well), this amounts to a sizable cut in the budget deficit. Economic growth is strong too, which also makes this easier, but so does high inflation. In fact, as far as I can tell, the announced deficit cut here - 1.6% in one year - is larger than that most developed countries undergoing “austerity” budgets. This sort of fiscal balancing would be politically impossible to impose if prices were in fact constant. It’s true that, for several reasons, this degree of fiscal tightening may never happen. Yet the simple fact that it was entertained at all points to the power of inflation in enabling real government expenditure cuts.

One of the chief attractions of higher inflation, from a Tea Party point of view, is that it would make budget cutting that much easier. Right now, with low inflation, to get lower real government spending you actually have to cut programs. That’s hard. It’s easier to let prices rise, lower the real value of all government spending, and then cap the level of additional spending. That’s a whole lot easier.

Irrationality in Action

2011-02-25T00:14:00.000-08:00

From the NYT's profile on Chris Christie:

When he was a federal prosecutor, Christie told the audience, he got to choose from about 100 health-insurance plans, ranging from cheap to quite expensive. But as soon as he became governor, the “benefits lady” told him he had only three state plans from which to choose, Goldilocks-style; one was great, one was modestly generous and one was rather miserly. And any of the three would cost him exactly 1.5 percent of his salary.
“ ‘You’re telling me,’ ” Christie said he told the woman, feigning befuddlement, “ ‘that no matter which one I pick, the good one or the O.K. one or the bad one, I’m going to pay 1½ percent of my salary?’ And she said, ‘Yes.’
“And I said, ‘Then everyone picks the really good one, right?’ And she said, ‘Ninety-six percent of state employees pick the really good one.’

Who are that four percent? Seriously, this is a huge issue for any rational actor model. Forget twenty dollar bills on the sidewalk, picking the more generous health plan in this context requires absolutely no effort at all.

Sweden's Socialist Republic of Children

2011-02-24T18:07:00.000-08:00

In his Introduction to Ender’s Game, Orson Scott Card made an observation that’s stuck with me:

Ender’s Game asserts the personhood of children, and those who are used to thinking of children in another way—especially those whose whole career is based on that—are going to find Ender’s Game a very unpleasant place to live. Children are a perpetual, self-renewing underclass, helpless to escape from the decisions of adults until they become adults themselves. And Ender’s Game, seen in that context, might even be a sort of revolutionary tract.

It’s one of the interesting aspects of that book that it’s written exactly from the perspective of a child, and treats their feelings and judgements as seriously as anyone else’s. This is one of the reasons the book is so popular among kids; though unfortunately it seems to generate the same sort of ubermench mentality people frequently pick up from Ayn Rand or Nietzche.

At any rate, I was interested by a recent Marginal Revolution post on the adoption of children by gay couples in Sweden. In some sense, if you were to take the revolutionary implications of Ender’s Game seriously, you would treat the private nature of the family as the source of generational exploitation and seek to handle child-rearing in a more public manner. Sweden, arguably does this; while gay marriage has long been acceptable there, adoption of children by gays is much less so. The argument is that the Swedes treat childrearing as a very public thing, while they care less about marriage. One commenter there adds:

This is absolutely true. The Swedish attitude toward the raising of children is absolutely centered on the welfare of the child; the rights of the parents play a very small role. Corporal punishment has been illegal for more than 40 years now, and for Swedes it is a reviled practice (people basically see corporal punishment as domestic abuse). The law also close to universal support (there's eight parties in the Swedish parliament, ranging from far left to the christian right to the blatantly xenophobic, and not a single one wants to repeal it). The viewpoint expressed in that quote is basically accurate: consenting adults can do whatever they want and it's nobody's business, but the public has a very large interest in the welfare of children.

Another person adds:

There also is a specific “ombudsman” for children, whose main duty is to promote the rights and interests of children.

It’s interesting to imagine this treatment as resulting from a certain Marxist response to the perceived systematic oppression of a given underclass of children. It would be interesting to imagine a future in which many more people see things this way, and perceive our current behavior just as flawed as we perceive the moral flaws of, say, the American South circa 1840. Alternately, this is another reason why though Swedish children frequently live in households with unmarried parents, they end up receiving excellent childcare. That sort of public support and social norms are difficult to translate to unmarried parenthood in other parts of the world.

Banking without Maturity Transformation

2011-02-20T20:19:00.000-08:00

Japanese banking has a pretty bad reputation, what with financial and real estate losses linked to a period of economic stagnation stretching into its third decade. Yet as Anil Kashyap and Takeo Hoshi illustrate in their historical overview on the subject — Corporate Financing and Governance in Japan — there’s a rich history here that goes back far further than the past few decades.

America’s banking system is based on a principle of maturity transformation that is well-articulated here by New York Fed President William Dudley (referenced by Ashwin Parameswaran):

“The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation—borrowing shorter-term in order to finance longer-term lending.”

By contrast, the Japanese system of banking has traditionally relied on strict silo-ing of finance. As envisioned by Matsukata Masayoshi, Finance Minister during the 1880s, banking evolved into three separate categories — commercial, industrial, and savings. Commercial banking was designed to provide flexible and short-term liquid instruments to firms; industrial lending was designed to meet the long-term, illiquid needs of industries, while the savings sector handled the needs of common folks.

In the jargon of finance, Japanese banks matched the maturity between borrowers and savers through specialized credit facilities. Industrial banks met the long-term needs of firms by getting capital from lenders willing to extend capital for long periods of time. The Japanese economy, between opening up and WWII, supplemented this specialized bank capital with active markets in equity and bonds.

After WWII, while most of the rest of the world downplayed the role of finance, Japanese policymakers spent a great deal of time figuring out how to fine-tune their financial system. Finance became highly regulated and even more segmented, with each individual sector of the economy financed through specialized banks designed to meet particular maturity needs. The national postal savings network channeled rural savings into the national network. Throughout the whole period, there was a belief that long-term investments ought be financed through long-term savings mechanisms, frequently raised in capital markets by banks, as opposed to consumer deposits.

Over time, banks started to play an increasing role in corporate governance, culminating in semi-oligarchic business groups for which the bank holding company called many of the shots. While these groups have been frequently disparaged, Kashyap and Hoshi note that, at least in the beginning, this form of relational finance allowed for effective oversight, governance, and reorganization of firms.

Japanese banking was a key factor behind Japan closing up to America before WWII, and recovering quickly afterwards. It certainly wasn’t perfect. But it’s worth noting that, before the banking crises in the late 1980s, liberalizers started to change the system. As Kashyap and Hoshi note, “This same pattern of botched liberalization preceding a major financial crisis has been told about many economies in the 1980s and 1990s. Japan’s was just the biggest of the disasters." Despite that major caveat, the authors still regard further liberalization and change along American lines as virtually inevitable and necessary — drawing numerous comparisons to supposedly superior Western banks. This is a rather bizarre stance to hold. I think in twenty years, you’ll be able to look at a book and figure out if it was written pre-2008 or post (this one is definitely before).

Instead of taking the view that deposits ought to match up with savings, American finance has chosen instead to operate via magic. Through magic, the idea is that you can take your liquid, small deposits that you put into an ATM and somehow turn this into large, illiquid investments in major companies. You can take a mortgage-backed security, and again — through magic! — use that as collateral for other purchases. The good part about this is that you can somehow operate the investment needs of a whole economy on virtually no domestic savings, but rather solely through the transactional cash in your checking account. The downside is that financial crises become virtually inevitable. Through deposit insurance, you didn’t see any banking runs on your checking account. But you did see banking runs on Investment Banks, and that’s really what made the crisis as bad as it was.

You're starting to hear people argue that the tools of modern finance lower the need for maturity transformation. Ashwin Parameswaran makes a pretty good case here, noting that we have plenty of long-term savers that can finance long-term investment projects without requiring the funds in your checking account. There are other good narrow banking options out there too. But these accounts typically still concede that maturity transformation made sense at one point in time. I think Masayoshi had things right all along, and had we looked there for inspiration earlier we could have gotten along without any maturity transformation at all.

Household Stagnation

2011-02-20T20:01:00.000-08:00

I've been meaning to comment on Tyler Cowen's ebook The Great Stagnation for a while. The book relies heavily on two claims: 1) There has been a dramatic slowdown in productivity in the past ~40 years, attributable to us exhausting all the low-lying fruit; and 2) Household income has similarly fared poorly in this period.

I can't really comment on 1), which I grant seems true enough. But I've written some on 2), relying on the work of Terry Fitzgerald, which I'll copy here from e21:

1. Inflation. The price indices used to compute per capita income are different from those designed to compute median household income. The price indices typically used for household income (Chart 1) are taken from a composite of sources, some of which take into account the prices faced by wage earners. The price index for national labor surveys (Chart 2) on the other hand, corrects prices on the basis of personal expenditures – the basket of goods consumed every year. These different series have different measures of inflation, and so result in different estimates of real income. A true apples-to-apples comparison results in a closer match between these two graphs, favoring the depiction in Chart 2.
2. Fringe benefits. Employers are increasingly likely to compensate workers in the form of fringe benefits, rather than cash income. In part, this is because certain fringe benefits, like employee-provided health insurance, are exempt from taxes. Estimates of household income do not take these into account, while they are an important part of the economy.
This is an important adjustment to consider, because we are frequently concerned with the overall quality of life for households, rather than the mechanism by which they consume goods.
Simply taking the first two points into account (using a common price index and counting fringe benefits) results in compensation that has grown 28% from 1976 to 2006 for the median worker, rather than stagnating.
3. Changing Composition of Households. Fewer people live in each household today than they did thirty years ago, and so gains in household income are divided against a greater number of households. While 64% of households consisted of married couples in 1976, this was true of only 51% of households in 2006.
Fitzgerald finds that every household type had large gains in income growth – gains obscured due to the changing composition of households. Married couples saw household income gains of 42% from 1976 to 2006, while single-female residences saw gains of 56%.
To be sure, inequality may account for some of the difference between household income and aggregate income. Fitzgerald estimates that Census income per person grew by 65%, while median income per person grew by around 50%. The remaining difference may be accounted for by a rise in inequality. But the important point is that households are not stagnating in the aggregate. America’s phenomenal productivity gains have reached its households.

Supply Side Mortgage Financing

2011-02-20T18:31:00.000-08:00

On the recommendation of Mike Konczal, I checked out Adam Levitin’s account of the housing (with Susan Wachter). It’s a pretty long paper with a single core idea: to figure out what happened with the financial crisis, look at prices and quantities. Levitin observes that the yields (ie, interest rates above other interest-bearing assets) on mortgage-backed securities fell dramatically during the subprime boom, while the quantity of such products grew dramatically. The lesson to draw from that is that a rising supply of mortgage finance must be the chief culprit for the crisis, not demand. If the demand for mortgages was rising (say, from federal housing policy), the price of risk in mortgage markets would steadily rise. The fact that they instead fell points to the role of increasing supply in lowering the risk premia on mortgages. Levitin attributes this falling cost to mispriced mortgage securities.

Here’s a graph from a Fed paper by Diana Hancock and Wayne Passmore I'll get to in a bit that illustrates this pretty well:

If you compare the pre-boom era "Normal" with the subprime boom, it’s clear that mortgage yields fell dramatically relative to Treasury rates (ignore the crisis era stuff).

This is a clever idea, but attributing all of that fall in interest rates to mispricing seems a pretty bad assertion. There are many reasons why yields could fall. As I just blogged, large foreign inflows of capital could lead to a lower price of risk, though this scenario isn’t mentioned in the paper. Though Levitin dismisses monetary policy quickly, Rajan has argued that periods of absolutely low interest rates might generate a pattern of increased leverage and yield-seeking that would describe this data equally well.

But what I found most troubling was the use of simple market yields. It’s true that a fall in mortgage yields could imply a lower risk premium, all else equal. But when pricing a mortgage, a lot more goes in than just credit risk. Borrowers of mortgages typically have the ability to pay back the mortgage in full — for instance, by refinancing their mortgage to a lower rate. This is bad from the point of view of an investor, since borrowers are most eager to "prepay" their mortgage once interest rates are low. So, at exactly the point when interest rates fall (and you have fewer good investment options), mortgage borrowers give you all this cash. To deal with this, when you lend money in the mortgage market, you receive a prepayment premium for taking on that risk, and that goes into pricing a mortgage. The factors determining prepayment risk, as well as other risk determinants, changed dramatically during the subprime boom era, so it's not clear whether a falling risk premia explains everything.

Fortunately, the Fed paper from above does break this out. While this can get very complex, one simple check is to compare the MBS yield over Treasury (graphed above) to the option-adjusted spread (OAS) over Treasury (graphed below).

The OAS here is designed to pick up the portion of the mortgage yield attributable to the prepayment risk. You see that the OAS spread went down quite a bit during the subprime boom years as well. Overall, the MBS yield over Treasury (which Levitin interprets only as credit risk) fell by ~.7%. Yet ~.55% of that fall is attributable not to changes in risk preferences, but instead due to changes in the premia for carrying prepayment risk.

And the fault for that goes exactly to the Fed/global investors. The Federal Reserve promoted a climate of low interest rates, while global investors too pushed interest rates down. In response, carrying the prepayment risk of mortgages became lower (as borrowers didn’t have much room to refinance at substantially lower rates), and mortgages became more attractive as an asset class. The net change in mortgage yields due factors other than the prepayment risk should be something like 15 basis points; and some of that may also be attributable to other changes in the financing climate (the authors claim a sizable fall in the roll-over risk in this period associated with having to refinance debt holdings. This, too, can be attributed to interest rates that were persistently low). Though the authors of the Fed paper don’t seem to break this out — it’s very possible that the credit risk for mortgages actually went up during the subprime years.

Not only that, but the stock of borrowers grew quickly in response to these shifts in interest rates, suggesting that homeowners in this period were highly responsive to the price of mortgages. It’s possible that factors like land use regulations, a bubble mentality, lower downpayments, etc. may have been responsible for that, and that responsiveness is as important as the initial shock.

To be sure, the fact that the risk premium seems to have remained roughly constant even as worse borrowers took out mortgages may suggest that the risk premium may not have been high as it should have been. And I don’t understand this field nearly as well as I should, so please check out both papers and tell me where I’m getting things wrong. But I call this as another win for the camp blaming the Fed/foreign investors.

Edit: Adam Levitin has responded in the comments. He makes the good point that the Fed paper only looked at Agency MBS; while the pattern may well be different for private-label MBS, many of which were given out to loans on an adjustable-rate mortgage.

For Capital Autarky

2011-02-20T18:00:00.000-08:00

V Anantha Nageswaran at The Gold Standard makes an excellent connection that may clear up the issue of economic “dark matter.” The basic idea behind the dark matter concept is spelt out in this piece by Ricardo Hausman and Frederico Sturzenegger, and relates to the presence of global imbalances. The United States, for the past decade, has managed to run up a massive current accounts deficit; meaning that the value of American exports has been consistently less than the value of American imports. To pay for this, there has been a corresponding boom in the degree of assets held by foreigners in the US. That is, America has been importing all sorts of goods from other countries, like say cheap toys or oil. To pay for that, instead of producing other forms of goods and services, foreigners have been content to hold American assets denominated in dollars.

This is where the dark matter comes in — it is the value of the financial assets held in the US by foreigners that are otherwise not accounted for. Figuring out what this stuff is was an big question before the financial crisis made other issues more relevant. But (much like the physical dark matter), it’s presence could be assumed from the nature of other statistics — in this case, the value of American goods and services.

Here’s a graph that sort of sums this up:

ie, there is a massive and growing current accounts deficit unless you calculate the value of these domestic asset holdings.

Now, cue Ben Bernake. With a group of co-authors, he has revisited international financial flows, and found some interesting results:

We present evidence that, in the spirit of Caballero and Krishnamurthy (2009), foreign investors during this period tended to prefer U.S. assets perceived to be safe. In particular, foreign investors—especially the GSG countries [“global savings glut” countries, primarily Asia and oil exporters]—acquired a substantial share of the new issues of U.S. Treasuries, Agency debt, and Agency-sponsored mortgage-backed securities. The downward pressure on yields exerted by inflows from the GSG countries was reinforced by the portfolio preferences of other foreign investors. We focus particularly on the case of Europe: Although Europe did not run a large current account surplus as did the GSG countries, we show that it leveraged up its international balance sheet, issuing external liabilities to finance substantial purchases of apparently safe U.S. “private-label” mortgage-backed securities and other fixed-income products. The strong demand for apparently safe assets by both domestic and foreign investors not only served to reduce yields on these assets but also provided additional incentives for the U.S. financial services industry to develop structured investment products that “transformed” risky loans into highly-rated securities.

To spell this out a little more: the argument here is that the United States experienced such massive inflows — roughly a trillion dollars a year for the US at the height of the boom — that they were sufficient to adjust interest rates and borrowing on a massive scale. The “dark matter” people wondered about were held in exactly the mortgage-backed securities (both by the GSEs and private suppliers) that performed horribly in the crash. Most countries that experience such forms of capital inflows have serious problems — think Asian countries before their crisis in 1997. In particular, these countries tend to see massive price appreciation in non-tradable, durable goods (especially real estate, but really all sorts of assets), and a loss of competitiveness in the tradable good sector.

This basically also describes the US, with two important areas of divergence. One, the financial sector had an active supply response as well, doing a great deal to manufacture the sorts of safe assets that were in high demand internationally (greater demand than American manufactures, at least). Many economists were broadly sympathetic to large amounts of foreign capital coming into America on the hypothesis that America’s sophisticated financial markets were best capable of handing these sums. Unfortunately, they were instead sophisticated enough to hide risks and create assets that appeared safe, but were in fact quite dangerous.

And second, there was no currency collapse after the boom. Several Asian countries after 1997, for instance, saw capital flee the country, followed by a major currency collapse. That hasn’t happened with America (though there was a great deal of fear prior to the crisis that exactly this outcome would happen), presumably because America’s crash means systematic failure for the world, and in response to that capital wants to remain in America.

Of course, it is difficult to establish causality here. Why did countries like China, Germany, South Korea, and Saudi Arabia invest their trade surpluses (from cheap goods, electronics, and oil) in America rather than purchasing American goods? For Asian countries, there was the goal of keeping a cheap currency and boosting exports; while the motivation for oil-exporting states is a little murkier. What's going on in Europe is even less clear, as they managed to end up with large amounts of assets in American MBS while having a roughly balanced import/export profile.

This narrative isn’t particularly new; if you’ve been following folks like Nouriel Roubini or Menzie Chinn this should be pretty familiar. So here’s some value added: the reformist goal of globalizing capital has been a catastrophic failure. Virtually every time countries import large amounts of cash, their economy gets trashed. In theory, this FDI could go to productive uses. In reality, it goes into unsustainable patterns of asset booms and crashes. There is the added worse impact of hurting the tradable sector of the economy, which is ultimately responsible for economy-wide productivity; as well as the added worse impact that the domestic financial sector also gets trashed, hurting you for years to come. A few decades ago, there was a big push to get capital to go from rich to poor countries, on the grounds that this could help them grow. Roughly, this failed. In the last few years, the argument instead has been that capital going from poor to rich countries could result in better global financial management. This, too, ended up pretty badly.

Playing financial regulation in an economy getting drowned in cash is like playing whack-a-mole. Even if somehow you prevent asset booms in any one particular area of the economy; the systemic impacts of capital flows ensure that some part of the economy will blow up. Banks will find ways to assume leverage and risk, regardless of what your regulations were before the boom. The political pressures of restraining this debt-fueled boom in consumption and investment are impossible to manage.

Really the only solution here is to return to some sort of Bretton Woods style world of tightly restrained capital flows. This is virtually impossible to re-generate, but the Fed doesn’t need any sort of international agreement to make international capital flow/currency regulation a major priority. This is already the case in many foreign central banks, but it is a mandate completely lacking at the Fed.

Which is why this situation is a little odd. On one hand, Bernanke is the guy arguing that these foreign capital flows are responsible for a large chunk of our problems (and not, say, the low interest rates he was a party to setting). But then he refuses to do anything about them, despite the fact that the Fed is the one actor in the economy with the capacity to do so. If you look around at developing countries, there are plenty of solutions one can come up with — Tobin taxes on capital flows, actual limits on capital flows, active currency interventions, and so forth. I’m all for free trade, free markets, etc.; but there’s no excuse for the Fed not taking these actions more seriously -- especially in light of their own view that this is what blows up crises.

Edit: Just to be clear, "autarky" was a poor wrong wording choice. Capital can and should flow from country to country, but these flows should balance themselves out on net, corresponding to a balance in trade as well.

The Decline of the Stock Market

2011-02-15T11:08:00.000-08:00

Felix Salmon has written a provocative piece arguing that stock markets are increasingly irrelevant to American capitalism. Reihan Salam has responded, arguing that a shift away from arms-length financing tools, like stocks, towards relationship-based lending, like private equity, could be a good thing:

I’m definitely on this matters, but I’ll just say that I think the death of the stock market is mostly good news. My admittedly crude sense is private equity firms do a fairly good job of allocating capital efficiently. We have evidence, from Nicholas Bloom and John Van Reenen in the JEP and elsewhere, that they have a managerial edge over publicly-owned and family-owned firms. As Amar Bhide argues in his wonderful new book A Call for Judgment, a case can be made that the U.S. has relied too heavily on arms-length finance rather than relationship finance, the approach taken by VCs that have deep, long-term relationships with the companies in which they invest. (Indeed, he argues that public markets in the U.S. suffer from excessive liquidity.) Our securities laws make relationship finance difficult if not criminal in many domains, and it is far from obvious that this has been good for the real economy.

Amar Bhide has written a good book, but I'm not entirely convinced. It's important to understand why stocks have become more important. If it were the case that companies on their own were choosing other financing options, this trend might be welcome. Rather, companies are instead frequently pushed away from the stock market by various worrying factors.

As Jeffrey Stewart argues, one such factor is new regulatory pushes (for instance, Sarbanes-Oxley) which have pushed the cost of listing higher to prohibitive levels. The whole market has also changed, possibly because of regulation, but also because of technology. Investment banks are perhaps less interested in underwriting new companies than in doing their own trading. Institutional managers are more interested in high-frequency trading among very liquid stocks than dealing with illiquid, new issues. Finally, there's an issue Felix has raised elsewhere -- that the tax code penalizes dividends and equity investments much more than raising debt, encouraging firms to stay away from equity. Overall, the stock market is less interested in deploying capital to entrepreneurial sectors of the economy than it is in making money on whether the tenth decimal place of a given price is correct.

It's true that Angel Investors, Venture Capitalist firms, and Private Equity have filled in the gap to some extent, particularly for tech firms. But even these financiers often require re-selling the company on a public exchange to cash out, so a poorly functioning stock market hurts them as well. The relationship funders rely on cooperating with arms-length finance too.

All these changes may make it harder for companies to get the financing needs they need as they grow up. Many companies around today -- Apple, Amazon, Microsoft -- went public very early on, and used that equity to finance future growth without giving up management. Yet new companies like Twitter or Facebook today rarely access the stock market until they get much larger. To an extent, venture capital funding may fill their early financing needs, though those backers may also be more likely to kill the company if it doesn't generate a quick, early return. You also need to be able to find such backers on a personal basis, rather than calling up some bankers and letting anyone buy your shares.

But the other alternative is selling out to a larger company, which seems to be one of the dominant next steps in the absence of cashing out through an IPO. This can frequently make capital allocation worse, to the extent big companies are bad at managing smaller companies they takeover. Many big companies, at least in tech, seem intent on buying out others simply to stifle competition.

A lack of easy access to capital markets also hurts incumbent firms that are already listed. Felix points to the high degree of corporate savings. In theory, companies should spend now if they have profitable projects, confident that the market will be able to meet any future capital needs. Instead, they are often opting to go for internal funding always. This can result in sizable capital inefficiencies over time.

You also need to think about the impact on investors. While the gyrations of the Dow may not have too much to do with real economic conditions, they certainly impact the 401(k)s of many individual investors. If the stock market remains a preserve of old, stagnant firms (missing Facebook, Twitter, and so forth); individual investors will miss out on the capital gains of a large sector of the economy, which will go instead only to a handful of connected insiders.

For an counterpoint to Amar Bhide, Anil Kashyap and others have a good book tracing Japan's financial evolution. I'll be blogging more on this soon, and am probably closer to Bhide than them. But they make some persuasive arguments -- Japan relied on a very equity-based system of financing pre-WWII, which worked very well; while the relationship style of banking that developed after the war resulted in substantial losses, particularly by the 90s.

It's hard to get a good sense of how much of this matters, particularly if you think that companies in general may need less capital to get going these days. But it certainly strikes me that lowering the capacity of the stock market to allocate capital was a particularly destructive move that has taken away an important financial choice for many companies. It's helpful that forms of relationship capital have filled in the gap in important ways. But surely it would be better to have both more venture capitalists, as well as a better functioning stock market.

More on TARP

2010-12-09T20:47:00.000-08:00

Karl Smith has kindly responded to my post on TARP:

Then a broker-dealer went bankrupt. The process of chaos began to unfold. We had what looked very much like a run. Given that narrative the response was to somehow stem the run. This meant insuring creditors against losses.
Various schemes were proposed. In the end equity injections were settled upon. The terms where not what I would have wanted but I understand the pressure of being in the moment.
After the equity injections our measures of panic began to subside and indeed have not come back despite the fact that housing has not recovered. This lends credibility to those of us who said that housing and bad loans mattered only to the extent that they were possibly creating insolvency and fueling a run.
Do we know for sure that this is narrative is correct – no. However, the level of certainty I think Gupta is asking for is virtually never available to us in real time and is hard to ascertain even looking back. My core case is that the narrative holds and continues to hold as we accumulate more data.

The ultimate argument here is "Things were going very bad; we did something; and things ended up much better than we expected. Maybe things could have gone better, but things did end up going surprisingly well."

First -- there's the question of whether or not TARP "helped." Ultimately, this relies on the unknowable counterfactual of what the world looked like without TARP. It also relies on assuming that the entire recovery was due to TARP. Yet as Donald Marron points out, "One reason that TARP appears much less expensive than originally predicted is that many of its investments benefitted from other government actions whose costs show up elsewhere in the budget." We did a whole lot to help the banking sector, and would undoubtedly have done even more without TARP. So to give it the whole credit is probably a bit much.

There's also a key phrase here -- "in the end equity injections were settled on." This is an interesting way of putting it. What actually happened is that Treasury asked for a virtual blank check ostensibly to support asset purchases, and then decided to purchase bank equity instead because they wanted to.

It's worth emphasizing again that the narrative that Treasury was selling -- that the world would collapse if we didn't purchase toxic mortgage assets -- was completely wrong. In fact we didn't purchase many toxic assets, and the world went on. Had we enacted TARP as envisioned, written into law, and sold to the public -- the result would have been hundreds of billions of dollars of taxpayer losses.

So the fact that we "settled on" equity injections reflects my primary opposition to the bill -- that we basically left the decision of how to spend $700 billion dollars in the discretionary hands of the Treasury. We are indeed fortunate that Congress failed to implement any meaningful oversight on the bill and the ultimate decision Treasury opted for was not the worst thing in the world (though, of course, TARP money has also been used as a political slush fund for things like HAMP, auto bailouts, etc.). But what was at stake in the bill was really the democratic principle that the legislative branch, not unelected bureaucrats, decide what we spend money on. Do we really think that giving Treasury the right to spend hundreds of billions of dollars is a good idea? Can we continue to rely on them reading the right bloggers?

I am sympathetic to this view though I take a slightly different tact. I tend to think that the government should have simply squeezed the financial system for everything that it was worth on the grounds that its the responsibility of the Treasury Secretary to act in the best interest of his clients. The taxpayers were his clients. Making more money for you clients is generally preferable to making less thus he should have tried to make more money.
However, it is important to note that TARP as structured was profitable on the bank side. It wasn’t simply that the taxpayer got his or her money back. Their were warrants that that gave the taxpayers a bit of the upside. I just don’t think they were big enough.
I understand the moral outrage and all but my general take is that the Government in this capacity should act to maximize taxpayer profits, not express taxpayer outrage. I realize that this is not a majority view.

Since when is the government supposed to run a hedge fund? Since when should the maximization of "taxpayer profit" be an objective of government?

The issue here is why is the government doing this at all? If the government made money on at least some of its investments; and the banks did well; why couldn't private capital flow in?

Everyone agrees that banks in 2008 needed to be recapitalized. But it was an open question whether this would be achieved through bankruptcy, or some mechanism of forcing banks to raise capital, or so on. There were a lot of options, each with costs and benefits. Some of them wouldn't have involved public money.

Unfortunately, it looks from Swagel's account that Treasury -- though aware of this problem -- spent months doing nothing about this. They wound up in September with a three-page plan that, as I've mentioned, would have barely helped. Perhaps they had the excuse that they were rushed and didn't have the time to properly consider, say, Zingales' bankruptcy proposal. But it's been several years since then, and Treasury doesn't have any serious bank resolution mechanisms that don't require public money.

TARP was no Success

2010-12-05T11:02:00.000-08:00

As over two years have passed since the extraordinary events of the worst days of the financial crisis in 2008, a new wave of retrospective and judgments are coming out to evaluate the nature of the federal government response.

In particular, a number of commentators have remarked favorably on the TARP program. At the time, widespread financial collapse seemed a distinct possibility. The immediate injection of large amounts of public funds, though unpopular, was followed by a relative stabilization of financial markets. The money spent on the program may even be paid back in large amounts.
Yet there are several reasons to be skeptical of TARP-revisionism:

1. No Silver Bullet. The case that TARP was a successful program of equity injection is based on praise by association. TARP was passed; the financial sector seemed to revive itself; therefore TARP must have fixed the financial sector.

Yet it is impossible to causally trace the improvement of conditions in the financial sector to any one program. The federal government also implemented a number of other programs to ease conditions for financial firms — from increasing access to the Fed’s discount window (resulting in trillions of dollars of loans to insolvent institutions), to easing mark-to-market accounting rules that allowed banks to hide losses, to unprecedentedly low interest rates which allowed banks to accept cash deposits from customers while paying virtually nothing. The scale and scope of the federal government’s interventions in the banking sector were enormous, and TARP does not deserve the entire credit for turning things around.

And though the situation remains better than in the worst moments of the financial crisis, the supply of credit remains weak. Small businesses report difficulties in obtaining credit. The mortgage lending market is almost entirely handled by the government; while the securitization market — a large financing source during boom years for everything from mortgages to student loans and airplanes — remains a shadow of its former self.

2. Costlier than you think. Suppose Hank Paul went to Las Vegas and put down $700 billion of the government’s money on the roulette table. Suppose he happened to win; though the casino only allowed him to take back the amount of money he brought with him. Would we think this provided an acceptable rate of return?

The answer is obviously no. TARP was wagered on a “heads-I-win; tails-you-lose” basis. If banks had done worse than they actually did, the taxpayer would be on the hook for hundreds of billions of dollars. If the banks did well (as they subsequently seem to have); the government merely gets it money back.

In other words — the government was not provided an adequate risk-compensated return. In backing the American financial system, the Treasury Department took on an enormous financial gamble on behalf of the American taxpayer, one that could easily have gone bad. It is fortunate that things did, in fact, go well. But that doesn’t prove that the original risky gamble was sound; only that taxpayers were lucky, and under-compensated for their investment.

Nor is it even obvious that the government will, in fact, actually recoup its entire investment. Money lent to GM and AIG may never be repaid in full. Loans to a number of financial firms were repaid in the form of equity, which may not recover in value. And, of course, the faster that firms pay back TARP money, the less effective the program will be in actually improving bank balance sheets. Finally – there are the long-term costs. Now that the government has established a precedent for bailing out firms that are Too-Big-to Fail (which include domestic automobile companies), similar companies will expect comparable guarantees in future crises. This will encourage risky lending, increase the probability of future crises, and lead to further taxpayer-fueled bailouts in the future.

3. Horribly Conceived. Most of the discussions of TARP, including this article, focus on the manner in TARP was executed: in the form of equity injections in financial firms and debt guarantees. It is easy to forget that, initially; TARP was conceived in a radically different manner.

As its name (Troubled Asset Relief Program) suggests, the program was designed in order to purchase toxic assets, in particular poorly performing mortgage-backed securities. The idea was that a handful of bad assets were “clogging” the financial system, and were really worth more than market price. By purchasing these assets at above market value, the government could assist financial firms while creating a viable market for these assets.

In retrospect, this idea was clearly and disastrously wrong. Mortgage-backed securities were not cheaply priced because investors were “panicking”; rather, it was because they were worthless. If anything, they were priced too high in view of the subsequent collapse of the housing market. If TARP were executed as planned and authorized by law, taxpayers would have lost hundreds of billions of dollars purchasing toxic assets.

Of course, it is easy to say so in retrospect. Yet even at the time of the program’s announcement, a large group of eminent economists wrote a letter to counter the program. Many of these figures were banking experts who were not averse to government support of the financial system. But they were all opposed to the idea of handling the government’s role through the direct purchase of bank assets.

4. Subversion of the Democratic Process. If both the public and economic policymakers were opposed to the program, how on earth did TARP pass? How was it transformed into a program of equity injections? This is real problem with TARP: that it represents a form of undemocratic discretionary bureaucratic overstepping.

In late September two years ago, Treasury Secretary Hank Paulson went to Congress. His message was essentially: “The financial system is going to collapse. We need $700 billion dollars. Trust us.” Unsurprisingly, further financial crisis ensued. Yet the following crisis merely increased the feeling of crisis and panic, further increasing the hand of the Treasury Secretary.

Fortunately, over time, the asset purchase aspect of the program was shunted to the PPIP, and then dropped entirely.

Yet this only means that money budgeted for one purpose was directed to another. While Treasury was authorized to spend TARP money as it saw fit; it ultimately dispensed funds in a different manner than advertised. Rather than going to Congress to meet budgetary needs for a fixed plan, Treasury viewed the original $700 billion as a grant to spend as preferred. There is some evidence that TARP funding went out to banks in proportion to their political ties. This type of crony capitalist insider trading is not conducive to a proper financial recovery, or public trust in the financial system.

The redirection of TARP funds did not stop there. GM and Chrysler qualified for relief under TARP, though both are automakers rather than financial firms. Over the past two years, TARP has been used as a general slush fund to handle any sort of general government spending that proved inconvenient to finance democratically through the regular budgeting process. For instance, HAMP was created using $40-50 billion dollars of TARP funds, yet has proved to be a dismal failure. Few Americans will stay in their homes because of HAMP modifications; most will only experience a delay in the foreclosure processes. Granting this sort of broad mandate and extraordinary funds to unelected government bureaucrats is, as the humanities types say, “problematic.”

Incidentally, the fact that Treasury was able to change its favored strategy after a matter of weeks and drop the idea of large-scale asset purchases altogether suggests that their preferred narrative of the crisis – that outside events pushed them into certain catastrophe-prevention measures – cannot be the case. Surely if the world was about to fall apart without large-scale government intervention, yet nothing like that happened in the absence of government intervention; the folks who saw government intervention as necessary were less than perceptive. Surely if the Treasury were in fact acting under the presence of hard constraints, it would not be able to change its favored policy completely in a matter of weeks.

5. There were Better Alternatives. Few banking experts would doubt that recapitalizing the banking sector is an essential priority in the aftermath of a financial crisis. When banks do not have capital, they cease lending, and the economic recovery remains tepid.

Yet at the same time that TARP was proposed, better alternatives were floated. Garret Jones, an Economist from GMU, proposed the idea of a “Speed Bankruptcy” that would recapitalize financial firms by converting debt into equity in a forced swap under a bankruptcy-like procedure. This would allow for banks to be bailed out by private capital, rather than public money. It would have forced bondholders — who largely went through the crisis unscathed — to bear the risk for which they enjoyed the return. Luigi Zingales advocated for similar proposals – and Phillip Swagel’s account of his time in the Treasury makes it clear that these ideas were seriously considered. There were plenty of ways to induce a private sector recapitalization of the banking system, from reforming the bankruptcy code to simply ordering banks to accumulate more capital by fiat. These steps may have involved going to Congress or skirting the law. They may have involved a different set of cost-benefit calculations. Yet as Luigi Zingales notes, nowhere in Swagel’s account do we see evidence that Treasury properly weighed the costs and benefits of various bank recovery options in a systematic manner. Everything instead hinges on various political “constraints” that apparently make an amendment to the bankruptcy code impossible, but permit Treasury to demand a $700 billion blank check from taxpayers.

In fact, Treasury was hardly the white knight of the crisis, working with distinction to do the (presumably unique) right thing in the face of the idiots in Congress. They actively shaped the narrative of what was going on; presented only the solutions they favored; and only saw legal obstacles as binding when they applied to policies they did not favor. They may well have been patriotic workaholics as well. That only suggests that no such agency, well-staffed though it may be, should assume that level of power or influence.

Ultimately, the difficulty in evaluating a program like TARP lies in defining the proper benchmark. Many commentators have mentioned the government recouping its investment as a sign of the program’s success. Yet as Felix Salmon points out; earning a financial return is neither a necessary nor sufficient condition of a successful government intervention. A financial rescue operation that “cost” the government money may have been successful if it were paired with substantial mortgage modifications, recognition of bank losses, and an eventual recovery in lending. A rescue operation that earned the government a substantial pile of revenue may prove to be a failure if money were simply directed at banks that were already financially healthy.

In fact, there may be a contradiction between the goals of recouping government investments and assisting financial sector recovery. Investments in healthy banks – like Goldman Sachs – may maximize the government return; yet do little to foster overall economic recovery. On the other hand, lending to risky banks – like Citibank – may prove more financially risky. Yet exactly because Citibank faces tangible economic risks, lending to it provides the chance to shore up a struggling institution and raise the odds of a financial recovery.

The ultimate lesson from TARP is that rushed responses to severe events rarely pan out as their architects intended. Building a financial system that never breaks down is impossible; yet building one that fails gracefully is in our power, if we embrace rule-based and punitive bank resolution techniques like bail-ins, instead of discretion-centered responses that demand public money and fuel moral hazard.

Sentence of the Day

2010-12-01T10:17:00.001-08:00

Germany, like China, is less prosperous than it seems, because its surplus production is geared to sale for claims that cannot credibly be redeemed for what the country’s citizens would want should they exercise their option to consume.

From Interfluidity.

Why we (still) need Cramdown

2010-11-28T17:06:00.000-08:00

Recently, I ran into Phillip Swagel's account of his time in the Treasury during the worst days of 2007-2008. While I think many people glazed over the lengthy section on homeowner assistance, I think this portion unwittingly provides an excellent overview of why some sort of cramdown legislation (ie, allowing bankruptcy courts to write down principal due on a mortgage) makes a lot of sense, and why past attempts to resolve the housing crisis through servicer-started modifications haven't been enough. I say "unwittingly" because Swagel was, in fact, opposed to cramdown.

Some background: as Michael Konczal, Yves Smith, and others have emphasized: every foreclosure represents a missed opportunity to renegotiate debt with a borrower. I think this is a bit overstated -- some people really are in the wrong house, not the wrong mortgage. Some foreclosures are inevitable, and the historical record on this issue is difficult to interpret. But certainly the number of forced sales represents a huge market failure. Banks and borrowers alike would be both better off if more housing principal was written down though some sort of modification.

Not Enough Mods

The first problem is that servicers aren't doing enough modifications, which involve both what I'll call "informational" problems as well as other "institutional" problems. The informational problems center around the difficulties in identifying troubled borrowers and extending them modifications. One way to solve this problem would be to extend an automatic modification to all borrowers who are behind on their payments. As we (may) have found out in response to Countrywide's announced modification strategy (which limited eligibility to such delinquent borrowers), this could be a recipe to encourage others to miss payments as well to qualify. There are some people who recover from delinquency to making payments on their own, and a mass-modification approach would write down their mortgages too.

So servicers, in general, adopt their own screening processes for dealing with modification requests. The problem here is that the scale of the problem has overwhelmed every existing servicer. In the past few years, servicers have grown rapidly on the assumption that the business is prone to economies of scale -- that larger companies are more profitable. This is true if every borrower makes their payment, in which case the servicer does little other than forward payments. But in bad times, servicing transforms into a business that requires a great deal of case-by-case dealing with individual borrowers (Amar Bhide style). It's simply difficult to scale up operations to deal with the scale of housing problems and hire the necessary loan officers. So you end up with a world in which the vast majority of delinquent borrowers fail to receive a modification after several months-- something like 90% by one estimate.

Aside from the various difficulties that individual servicers and banks have with sorting and dealing with delinquent borrowers; there is broader "social fairness" point. The issue is to what degree public money ought to be directed towards indignent borrowers who fail to make payments on enormous McMansions. Remember that the infamous rant on the trading desks that started the whole Tea Party idea was primarily about venting against such borrowers receiving too much assistance. These concerns seem to have played a large role, according to Swagel, in limiting government involvement.

Then; there are the institutional problems, as Swagel lists in exhaustive detail. Second-liens attached to properties have the power to hold up a modification on the first mortgage; as they view the resulting higher cash flows as going primarily to the holder of the first mortgage. Securitized mortgages in general face institutional problems in providing for sufficient modifications, as the servicers on loans that were packaged and sliced are rarely properly compensated for bothering to modify a loan. Even among "portfolio" loans held by banks; banks are reluctant to realize capital losses on mortgages by writing down the principal. Finally -- there are broader social external consequences of foreclosure that banks don't take into account -- like the effects on nearby housing prices, and municipal revenues -- that mean we probably need more modifications than banks would prefer. It appears that Treasury has known much of this for quite some time.

Mods of the Wrong Type

Aside from extending too few modifications, servicers and banks are also extending modifications of the wrong type. Driven by the pressure to meet the demands of bondholders (in the case of securitized mortgages), or avoid realizing capital losses (in the case of portfolio loans and those held by Fannie/Freddie); private modification efforts have often worked by lowering the interest rate faced by the borrower; while in many cases extending the length of the loan. The principal on the loan then frequently does not change; this means that the economic value of the mortgage remains the same. If that property was underwater -- the mortgage worth less than value of the property -- this doesn't help at all.

Modifications, too often, only targeted the "front-end" debt-to-income ratio. That is, mortgages were only restructured so as to allow homeowners to pay at most about a third of their income on their mortgage. However, this ignores the various other debt commitments borrowers face -- like credit card and auto debt -- which are frequently binding constraints. While computing modifications on a front-end basis is a lot easier, it also leaves many homeowners with more debt commitments than cash flow.

It's easy to say "this is all obvious now"; but I think you could have said the same even before the crisis. Without really changing the structure of a mortgage by writing down its principal, you don't change the economic decision available to consumers.

Crucially, according to Swagel's account, all of these bad characteristics (which were initially the product of constraints faced by private subprime servicers) became written into government policy through the IndyMac modification effort (overseen by the FDIC) and HAMP.

Cramdown

Cramdown actually solves all of these problems. Rather than requiring banks to sort through millions of modification requests, bankruptcy puts the onus on borrowers and bankruptcy trustees. The homeowner actually needs to go ahead and file, which -- given the massive stigma and damage to credit that results -- represents a huge deterrent to casual filers. Upon filing for a Chapter 13 plan; borrowers' mortgage debt (along with all of their other debt) is instantly written down to a perhaps sustainable level, with little fuss. Bankruptcy can't do many things; but it is very good at filtering between types of borrowers. All the reasons why we have wimpy and too few modifications immediately vanish. Plus -- by granting homeowners a powerful stick -- servicers may be more aggressive in modifying on their own.

It also solves the "indigent borrower" issue. While many people are upset about government-sponsored HAMP efforts, many people at least see bankruptcy as characteristic of America's failure-tolerant culture. The costs of bankruptcy are principally borne by the borrower; not by taxpayers.

After outlining the various reasons that existing modification policy failed; Swagel provides an entirely unconvincing argument for why Treasury fought hard to avoid cramdown legislation (which did in fact pass the House): it would have drained "private capital" from the housing market.

The fairest way to interpret this statement is that Treasury at the time was concerned about maintaining supply and demand in the housing market. While cramdown would have reduced the flow of distressed properties hitting the market (by putting those borrowers in bankruptcy, and allowing them to meet smaller monthly payments); it may have also reduced the capital available for new borrowers. The net effect, in a given moment, is hard to figure out; but clearly Treasury was worried that it may force prices to go down even further.

But this is a very short-term assessment, a trend that seems to be inevitable during the course of a crisis. Sure, we have have temporarily lowered the flow of new buyers. But the long-term impact of fewer distressed properties hitting the market would have been massive. At what point should Treasury deal with the short-term pain to secure a huge long-term benefit? Also, as has been the case for quite some time, there is virtually no private money in the mortgage market. Virtually all mortgage originations are financed by the government, through Fannie/Freddie/FHA. Having less private capital flow into the mortgage market would be basically costless right now.

This other problem with this argument is that it completely fails to evaluate the costs and benefits of more private capital, instead seeing that as some sort of ultimate good (much like "liquidity" is often treated). Personally, I think higher capital costs for high-risk borrowers (resulting in smaller houses and more renting) would be phenomenal. We could even design cramdown to avoid impacts on future crises -- for instance, by making it retroactive only. Swagel might complain that this still signals to lenders that our approach to contracts has gotten more flexible. This may be the case, but that really seems a second-order consideration for (hypothetical) future private lenders.

Also, what's the alternative? Instead of cramdown, we got a horrible 50 billion dollar modification plan (HAMP) that has perpetuated all of the bad practices of previous subprime modification efforts. Suppose we think of cramdown as some sort of "tax" on all people with bad credit to benefit some homeowners who file for bankruptcy, paid for out of the higher cost of privately provided credit. By what logic is that better than an actual, massive, tax that redistributes income from renters to homeowners in a massively inefficient manner? Swagel might argue that he didn't institute HAMP. But as he argues elsewhere, there is a natural continuity between the Bush and Obama Administrations on housing policy. And the Bush Treasury's failure to properly put in modifications led directly to the Obama's Administration's push on this issue.

The last argument Swagel gives is that cramdown would revive the 2005 bankruptcy legislation. Personally, I see that as a good thing; given that I view that legislation as the source of all current evils (for instance, see this Michelle White paper on how making bankruptcy harder encouraged the foreclosure crisis). But then, as with so much of Swagel's account, this debate turns into unverifiable accounts on political possibilities. Well, the reality is that the House passed cramdown legislation without broader implications. Perhaps the Senate could have as well, if Treasury and other stakeholders were as committed to the idea as they were to HAMP and other abominations.

I can't guarantee that cramdown would have "worked." But I can guarantee that it would have allowed as many people that tried to qualify for HAMP a better way to afford their mortgage, without costing taxpayers 50 billion dollars. A lot of the criticism and commentary over the Treasury has focused on their high profile decisions to bail/not bail out Lehman, AIG, etc. But I hope more people look at their approach to homeowner assistance, and their decision on cramdown in particular.

Quantitative Easing

2010-11-22T23:28:00.000-08:00

To clear up the debate over quantitative easing, there are only three relevant questions: (1) Should the Fed ease ever? (2) Should the Fed ease now? and (3) Is 'Quantitative Easing' the right strategy? If you disagree with the Fed about QEII, you have to say no to one or more of those questions.

Should the Fed Ease Ever?

This is a surprising one. If you would have talked to me a few years ago, I would have said that there is a widespread consensus around the idea that the Fed should loosen policy to make recessions easier (and ideally tighten in good times).

Yet now there has been an outpouring of anger at this idea -- led by intellectuals of many stripes, but politically primarily by Republicans. The concern is that "printing money" is not sufficient to handle "primarily structural" problems in the economy. The underlying idea here is that purely nominal changes reflecting the money supply can't have an effect on the real economy (according to Paul Ryan, they never have).

The other critique, bizarrely, enough, is that the Fed eased too much during the boom years, generating a "bubble," and more easing now might lead to runaway inflation. Sometimes, you hear both concerns from the same people. But let me focus first on the idea that monetary policy can't do anything.

As Christina Romer (former CEA Chair) has pointed out, the entire recovery the US had from the Great Depression can be accounted for by monetary stimulus -- in particular, the decision to get off the Gold Standard (which removed a huge constraint on how much money we could print). Vockler generated a huge recovery in 1983 by loosening policy. And as recently as 2000-01, the Fed’s easing prevented what were actually quite enormous real economic losses (comparable to subprime losses) from turning into worse outcomes.

The theory of how this happens has been explained by Milton Friedman, among others. Paul Krugman has a particularly good explanation of this using a parable of the baby co-op, that I'll provide a lengthy excerpt from:

A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It's a mutually beneficial arrangement: A couple that already has children around may find that watching another couple's kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip--pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable--and these young professionals certainly were--what could go wrong?…

Now what happened in the Sweeneys' co-op was that, for co

mplicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple's decision to go out was another's chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op's members were lawyers, it was difficult to con

vince them the problem was monetary. They tried to legislate recovery--passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy….

Above all, the story of the co-op tells you that economic slumps are not punishments for our sins, pains that we are fated to suffer. The Capitol Hill co-op did not get into trouble because its members were bad, inefficient baby sitters; its troubles did not reveal the fundamental flaws of "Capitol Hill values" or "crony baby-sittingism." It had a technical problem--too many people chasing too little scrip--which could be, and was, solved with a little clear thinking.

Sometimes, your problems really are just monetary. When the demand for holding money shoots up, and we don’t respond by increasing the supply (we refuse to "debase our currency"); people start to hoard cash, and we get a recession.

But even if you don't buy that logic; clearly we can't go on with the same money stock that existed, say, in 1913. We need more money from time to time, and that happens through two channels -- (1) banks can do more lending, resulting in more privately generated money, or (2) the Fed can exchange bonds held by banks for cash, in effect giving banks a "licence" to print more money. In our system, the actual process of money generation actually happens through banks, but the government has a key role through monetary operations that allow or cancel what are in effect "money printing licences."

Again -- there really shouldn't be any debate over this. We need to print money from time to time. This is especially important when there is an excess demand for money -- at which point purely nominal changes can result in actual, large-scale effects in the economy. Room for reasonable debate starts at:

Should the Fed ease Now?

We have various statistics on governing monetary aggregates and indicators. Most of them suggest that money growth is below trend:

M2 is a basic standard of "money;" the one preferred by Milton Friedman. Here, you can see that growth in M2 is below recent trends:

M3 is another measure, that incorporates broader monetary items. According to Gary Gorton, it's a better measure of money in the modern world, where financial instruments -- like repos or Treasuries -- serve as money in financial markets. That's actually declining.

Then there is inflation. The most recent data show that “core” inflation is weighing in at .6%. If you were to better impute ongoing house price declines (or hedonistic quality improvements), that would be even lower. (It would be higher if you counted some commodities. But the price growth in those items is driven primarily by strong demand from emerging countries, not from monetary expansion in the US.)

Of course, low current inflation may be a temporary sideshow. Inflation could jump up in the future, as people have argued for several years now. But instead of relying on unfalsifiable fears or concerns -- I prefer to look at the markets. What do markets think about future inflation? The Cleveland Fed has the best figures; that show inflation expectations are low and falling:

So, by every possible measure, the money supply is low and trending lower. It’s projecting to be low in the future as well. If you think that money growth should be a little counter-cyclical to meet greater money demand, it's too low by far. Even if you think that the Fed should only have an inflation target around 2% — money supply is too low.

As you have probably heard, Japan spent a lost decade (really, now 18 years) going through a deflationary period enduring all sorts of economic pain. Here’s America relative to Japan on that path:

Deflation, in general, isn't necessarily a bad thing. America went through deflationary trends in the 1860s-1870s and the 1920s but did just fine. When deflation is driven by supply-side technological improvements that reduce secular prices, the Fed does not need to deliver inflation (arguably, this was the case in the 2000s; when trade and technology may have reduced prices on their own; and Fed intervention just led to a "housing bubble."). Deflation is a bigger problem when it’s driven by shortfalls in demand; and gets you a world like the baby co-op where all members are afraid to run down babysitting script for fear that they would be unable to pick one up later.

Deflation during times of economic stagnation is nothing short of catastrophic. The Japanese have been unable to generate enduring economic growth for, again, close to two decades now. High inflation is easy enough to end with central bank that cares about the issue -- but deflation on Japanese lines is near impossible to cure. In my view, the massive costs of persisting in a Japan-like ditch are sufficiently large (and the odds that it will happen are high enough); suggesting that we should be prepared to pay a high premium for an insurance policy against such an outcome. Fortunately for us, this is really a negative premium considering the benefits that inflation closer to target would have for us today.

If anything, our experience would be worse than Japan’s. As Michael Pettis points out, Japan had the fortunate chance of dealing with economic stagnation by undergoing domestic rebalancing. Though economic growth was slow, households earned a steadily larger share of the pie. America doesn’t have that option, given how large household consumption already is. American households in a deflationary environment would likely be hit by a double-whammy — as growth stagnated, households would readjust their consumption share downwards as they started to save.

If the costs of low inflation are high, the costs of dealing with high inflation are manageable. As Scott Sumner has argued; the Fed has many more tools to combat inflation that in the 1970s. Futures markets indicate market expectations about future inflation, ensuring that the Fed won't be caught off guard by unexpected rises in inflation. Plus, with economic slack and underutilized labor and equipment, rises in nominal spending would presumably manifest in the form of greater utilization, rather than higher prices. This allows the Fed a greater degree of cushion in setting policy.

The Fed also has a new tool — it’s policy of paying interest rates on bank excess reserves. Banks now have the option of holding extra money at the Fed and earn interest, instead of extending loans in the real economy or buying bonds. The Fed’s decision to undertake this policy explains in part why the traditional monetarist fears about a larger monetary base generating inflation haven’t panned out. The Fed’s (brand new) policy has short-circuited the normal process of money creation. The upside is that future increases in inflation will be easily curbed by the Fed if it is willing to use this tool.

Finally, there's the fact that while higher inflation is hardly a cure-all, the costs of having unprecdentedly low inflation right now make solving nearly every other problem in the economy much harder. It’s harder to rebalance global consumption (more savings in the US, more consumption elsewhere) while the dollar is strong. It’s harder to dig out of a housing debt overhang when inflation is lower than home buyers anticipated when they drew up contracts. It’s harder to deal with government debt if the Fed isn’t purchasing that debt. All of these are “real” economic problems, but they’re impossible to manage in the presence of deflation, and difficult enough when inflation is as low as it is.

While easing may generate the "risk" of inflation, it's worth considering what that means. There's no good economic evidence that inflation has any bad consequences until it hits the double digits. India, for instance, is managing 8% economic growth just fine even as inflation nears 10%. Inflation was around 4% when Vockler declared a victory against high inflation (subsequently, he was attacked by Republican officeholders for letting inflation fall below that — how times have changed).

Why QE?

To sum up; we have a deflationary environment; the Fed has ample tools to attack inflation in the future, and it has in effect a "magic ball" that allows it to anticipate changes in inflation before they happen. On top of that, higher inflation would, if anything, be good; while the costs of extended deflation could be quite bad.

The only reason to have a debate about this at all is that the traditional tool of monetary policy — the Fed purchasing short-term Treasury debt in exchange for money — has run out. With short-term interest rates near zero, banks simply take the money from any Fed asset purchases and send it right back to the Fed to earn comparable interest rates as excess reserves. Short-term asset purchases now simply change one low-interest bearing government asset for another.

But suppose, as Rortybomb and others have suggested, that we simply find that we are mistaken about interest rates, and the Fed actually could ease a little more through the conventional route. It’s tough to imagine that anyone would actually then oppose further easing. After all, the Fed bought a great deal of government bonds (lowered interest rates) in 2007-2008; a period of time during which growth was higher than now, inflation was higher, and growth in monetary aggregates was also higher. No one complained about debasing the currency then.

The entire debate thus revolves around the fact that the Fed, in trying to ease while short-term interest rates are zero, is going to purchase government bonds of slightly longer duration (quantitative easing). That's the only difference. You can call this an "unprecedented" or "risky" strategy if you like, but really it’s virtually identical to the policy we would all like to do if short-term interest rates were a few points higher.

There is one and only one new concern that QE raises, as Greg Mankiw points out:

If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.

The issue is that, if higher inflation hits, the Fed will be forced to deal with that. If it contracts by selling the same long-term bonds it purchases today, it may be forced to realize a nominal loss. But losses from central banks are a little odd to think about. The Fed practically has a license to print money. It’s normal activities also generally produce a sizable surplus, which typically goes to the Treasury (but a greater proportion of which could stay with the Fed to counter realized losses). Bernanke considered this issue extensively in his speech to the Bank of Japan (in which he urged the adoption of various tactics to deal with Japan’s deflation and zero-rate problem), suggesting that:

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy.

He also suggested a bond conversion (or interest-swap) proposal between the Bank of Japan and the Ministry of Finance (here, the Fed and the Treasury) that would protect the Bank of Japan (Fed) from any subsequent interest rate changes. This would, in effect, reduce the scary-sounding “quantitative easing” to normal monetary policy — on which there should exist broad consensus that we need to ease.

So, again, that's the only real "risk" that QE induces -- the risk that inflation will somehow jump up dramatically (even though money growth is trailing GDP, and markets don't expect it), that the Fed burns through trillions of dollars of short-term bonds in responding to that (bearing minimal losses); and that the Fed then somehow takes minor nominal losses on their long-term bond purchases. And we even have solutions to that if we can get the proper coordination between the Treasury and the Fed (bond conversion or the Fed keeping more of the money they make). When balanced against the risk of letting inflation expectations de-anchor from historical norms and lead to a deflationary spiral, I think that's a pretty fair tradeoff. Certainly I don't think this risk in any way justifies the sort of vituperative rage that has been directed against the Fed.

Plus, I don't think QE skeptics have fully thought through their position. It is entirely resonable, in my view, to suggest that the zero-rate bound should represent a real constraint on the actions of the Fed -- that the Fed should simply not purchase any long-duration assets. So if short-term interest rates are zero; tough luck.

But if you really believe that, the resulting low inflation means low (nominal) interest rates, which means that the Fed will run out of its traditional ammo and hit the zero-rate bound again and again, and be left paralyzed. This means that we really need insurance against hitting this bound, in the form of higher inflation that results in higher nominal interest rates.
Put differently -- if you want low inflation (ie, 2%); you also need to give the Fed the tools it needs to conduct monetary policy when interest rates hit zero, as they will frequently with inflation that low. Just complaining about printing money isn’t an option — everybody needs to believe in easing now (if you don’t think the zero-rate bound is a real barrier), or easing later (to generate higher long-term inflation).

The criticisms I take more seriously argue that QE will do little. I think the market responses to the anticipation and announcement of QE2 demonstrate that it can do some good; but I also think it won't do much.

But what we need to do then is pair it with policies that will do good. For instance, we can end the Fed policy of paying interest on excess reserves, and then have the Fed buy many more government bonds of all durations. That way, banks will take the money and put it somewhere in the economy. Even if they park it in other bonds, that will lower interest rates, push the seller to do something with the money, and at some point result in higher nominal spending. Or, the Fed could just eliminate this policy now, see what the current $1 trillion of parked reserves could do, and then think about future asset purchases.

Alternatively, the Fed could try to push money out by other ways. A combined Treasury-Fed operation is a commonly envisioned tactic -- this would work by having the government spend money in some way, and have the Fed foot the bill by buying the resulting additional government bond issuances. Even John Cochrane, who is skeptical of both monetary and fiscal policy, agrees that this would have some effect. So do the modern monetary theory guys. Bernanke, too, stressed this sort of monetary and fiscal cooperation in his speeches to the Japanese. Either his logic was wrong then, or it’s wrong now.

Finally, I'll say that for me, this issue is as much moral as it is purely practical. I was drawn to the bipartisan, technocrat economic management school not because of the patently unrealistic assumptions about human behavior, but because I saw it had real solutions to solve major economic problems. You don't have to suffer a Great Depression -- you just need to set your monetary policy correctly, etc.

Now, I'm worried that so many commentators have seemingly checked out of these debates. You see many people complaining about new policies, and worrying about supposed "risks" or "worries" that don't exist in data coming in statistics or financial markets. There are fewer and fewer people with tangible solutions on how to solve this mess. I think that erodes the moral legitimacy of capitalism. I think no economic system that tolerates 10% unemployment is acceptable; and something must be done. If you don't like QE; if you don't like the alternate options here; then what's your plan? What's your strategy for avoiding a Japan death trap/Mad Max world? For Krugman and Bernanke, it was frustrating to watch policymakers in Japan seemingly self-destruct in the face of difficult economic times. Turns out it's also frustrating to live in that world.

Is the US More like Italy or Japan?

2010-11-08T18:41:00.000-08:00

The great folks at e21 have a piece up arguing that repeated comparisons of the US to Japan may be inapt; and rather that Italy might be a better comparison. The lesson is that quantitative easing might not be a cure all:

Just as Italy went from one financial crisis in 1974 to another in 1976, is the U.S. poised to follow its 2008 financial crisis with another in 2011 or 2012? Maybe. Just as Italian easy monetary policy boosted domestic demand, which could not be satisfied by domestic production even as it reduced the value of the lira, the Fed’s policy has stimulated domestic consumption and reduced the trade-weighted value of the dollar without materially closing the current account since 2008.

I understand this point of view and appreciate the role that skeptics are playing here. I'm also still trying to think through these issues. At the same time, there are a number of reasons why the lessons from Italy might not apply.

First -- the 70s were a tough economic decade for many countries. High energy prices, unions and structural problems in Italy's economy drove prices higher and deficits up. This was a time of great political instability. In particular, the pressures in maintaining both a fixed exchange rate while paying more for oil imports seems to have been a huge driver in Italy's current accounts. But let's accept for a moment the monetarist idea that changes in inflation were ultimately due to monetary issues.

To the left is a graph of Italy's growth in M2, taken from an article linked to in the e21 piece (their big crisis was 1975). As the authors of that note -- the problem was not political pressure to monetize debt, but rather a general desire to pursue expansionary policies. This led to a quite substantial growth in the money supply, at least in M2 (Friedman's favorite monetary unit), which in turn seems to be associated with inflation and currency depreciation.

At the same time, there is also evidence that wages were growing steadily as well, in part due to pressure by unions. To the extent that real wage increases faster than productivity led to inflation, the lesson from Italy that "quantitative easing can be bad" might be less applicable; especially given how weak wage increases have been lately. But, again, let's take purely the monetarist point of view for the moment. How does America compare?

David Beckworth provides a graph for the US, here:

Clearly, M2 growth lately has been below both historical averages and Italy. It appears at 2-3 percent here. Meanwhile, other measures of monetary bases -- like M3 -- are actually declining. As Gary Gorton has suggested, M3 may be a better indication of what "money" means in today's economy. It includes, for instance, at least some repurchase agreements, which operate today as "money" in the market for financial assets.

Japan has had figures that looked much more like the US today than Italy. Milton Friedman observed that during Japan's "troubled times," money (which he defined as M2 + CDs) grew at just 2%. For Friedman, this was not just unacceptably low, but was causally linked to their terrible economic performance as well. Since interest rates on short-term government debt were close to zero; he recommended quantitative easing as a matter of course. He would have been shocked if you suggested to him that in fact he was recommending an unproven idea as risky as geoengineering -- for him, as well as many other Japan experts, the only plausible explanation for the Bank of Japan's failure was their complete ineptitude.

And, of course, the fact that Japan and the US suffered banking crises means that velocity in these countries (rate at which money turns over) was much lower. As Friedman has argued; central banks ought to adjust the monetary base to keep pace with movements in velocity and output. So the tepid growth in monetary bases in both the US and Japan can be really destructive.

By the way, here's a comparison of Japan and US along inflation:

It's difficult to judge what the lessons from Italy are. Monetarist skeptics like Modigliani will presumably argue that Italy only shows that union-brokered wage increases in the face of a stagnant economy and oil shocks can be inflationary. Monetarists might instead argue that double-digit growth in M2 eventually results in inflation. However, it's not clear why that result should give us pause given that money growth in the US now is an order of magnitude lower.

Finally, if the results from Italy represent the worst possible result of quantitative easing -- it doesn't look that bad. Italy, after all, recovered and grew fairly rapidly afterwards; passing the British economy by 1987. Meanwhile, the only sorpasso that Japan experienced was their being lapped by China. I think they'd happily trade their problems for the post-1975 experience in Italy, and I think in a few years we'd like to take that trade as well.

Do Taxes Matter?

2010-09-29T18:54:00.000-07:00

Elsewhere, I’ve written about the long-run negative consequences of taxes, and the possibility that the top of the Laffer Curve is not so far off. Karl Smith takes exception to these arguments, when looking at this graph:

The supply of working-age people into the labor market seems to be largely driven by changes in monetary policy, rather than changes in taxes. For Karl, this seems to imply that the choice to enter or exit the workforce is largely pre-determined, and responsiveness to to taxes must be pretty low (he has another recent post that makes the same argument; though it is only shows up in my Google Reader).

I’m pretty skeptical of this line of analysis. Rather than eyeball aggregate data like this, I’d rather look at evidence that spans different countries over time, carefully calibrated analyses of specific tax cuts, or modeling based on economic data. All three methods seem to suggest that the responsiveness of people to taxes is pretty high. Even Saez, who recently won a MacArthur genius award and is generally regarded as being on the left on these issues, has a recent paper that argues the impact of taxes can be sizable, especially for those that itemize deductions and higher-income folks (his paper also suggests that the impact of taxes is taking place through channels other than simple labor supply). I think this is all evidence we should take seriously, regardless of what aggregate data suggest.

But none of this directly answers his chart. Well, here are a few more charts:

This one shows the average federal tax/GDP ratio of the American economy going back a few decades. Across a wide variety of tax regimes that have drastically changed average and marginal tax rates, the average tax/GDP ratio has stayed within a fairly tight band. It seems to be driven far more by changes in the business cycle (especially the stock market) than changes in statutory tax rates.

I wouldn’t subscribe to this interpretation entirely: but one plausible reading is that the long-run Laffer curve maxes out for a pretty low value. Successive tax cuts from the high rates of the ‘50s have been accompanied by economic expansion. Tax hikes from the ‘80s have been accompanied by economic slowdown. A tax/GDP ratio of 18% is, if not optimal, close to a maximum of what can be obtained without seriously affecting work incentives. European countries get higher tax/GDP ratios primarily by lowering GDP, not through higher tax revenue.

Here’s another graph in support of that interpretation:

Somewhat surprisingly, America gets about the same tax income per capita as Western European countries with far higher tax rates. That’s because America’s lower tax rates balance out Europe’s lower income almost exactly. I don’t like generalizing about “Europe”, which contains a variety of different systems, including the low-tax, high economic freedom Switzerland. But a simple reading of this graph would reinforce the conclusion that higher tax rates primarily lower economic output, rather than raising tax revenue.

Back to Karl's original graph — note that labor force participation rates are lower than Europe, at least normally. This was not the case several decades ago, which suggests that “culture” is not the reason. The culprit, depending on the country, seems to be a combination of rather high rates of taxation, high rates of people on disability, and the disincentives of social security provision.

I’ll add finally that this debate plays into whether or not we have a sustainable fiscal future. If you look at this CBO graph:

You’ll see that they project rapidly rising entitlement spending, driven primarily by Medicare and to a lesser extent by Social Security. You’ll also see that they project a rapidly rising tax/GDP ratio under the "baseline scenario", which will increase tax/GDP ratios far above historical norms (though this scenario would call for a full repeal of all of the Bush tax cuts, and so is not probably the path we will take). If the CBO is right, we can easily achieve massive increases in tax revenue without seriously affecting work incentives. If this story above is right (and, again, I’m not sure I’d agree with it entirely), a sharp rise in taxes/GDP would not be accompanied by large rises in tax revenue, but rather by stagnant growth in GDP.

The point here isn’t that we can raise tons of tax revenue by cutting taxes — I think the opposite is true. Also, I suspect labor force participation is pretty fixed for a large chunk of the population. But I think the aggregate data cut both ways, and the best evidence we have suggests that taxes have pretty bad effects.

To make a petty partisan point, I’ll also add that though the Republican plan for dealing with deficits in their Pledge has gotten a lot of flack, I don’t quite see how the Democrats are targeting this issue either. After slamming Bush for a decade for his irresponsible tax cuts, they now plan to extend almost all of them — except for those that may actually grow the economy, as the CBO suggests. Meanwhile, they are rolling out new expansions of healthcare entitlements and plan to hold the line on Medicaid, state and local spending, and Social Security. Conflict efforts in Afghanistan will ensure that large military cuts are not forthcoming either. How exactly is this supposed to be affordable? I really hope Karl is right on this one.

Rajan, the GSEs, and the Housing Bubble

2010-09-26T15:58:00.000-07:00

Krugman and Rajan have had another round of combating articles going around.
I want to focus on one bit: the role of the government in creating the housing boom. This story is an important part of his book, Fault Lines, and I’ve argued before that this association is a little dodgy.

Krugman, of course, has made similar arguments too. In his response, Rajan switches his argument up a bit. He recognizes that Fannie and Freddie actually saw a decline in their activity during the worst years of the crisis. But he doubles down on his argument that the GSEs went into subprime; and he argues that they had a crucial role in “priming” the bubble.

The first claim — that the GSEs had a heavy subprime exposure — is an argument mostly made by Ed Pinto, a former credit officer for Fannie, and Calomiris from Columbia. They seem to rely on their own classifications of “subprime” . Most other sources find otherwise. For instance, the Fed claims 84% of subprime mortgages in 2006 were made by private lenders. Rajan argues that it is crucial to see not only how Fannie/Freddie were changing their overall market share during the boom, but also how they were changing their holdings of subprime. Yet it looks like they went from holding 48% of the subprime mortgages that went into the secondary market in 2004 to 24% in 2006. The quality of subprime mortgages, too, drastically worsened during that period, so Fannie/Freddie's subprimes were of far higher quality than those held by private companies during the boom.

Rather, it looks like the real problem was that private securitization drove mortgage origination. Just under three-quarters of mortgages went to securities in 2007, up from 56% in 1994. The trend was even more stark for subprime mortgages — 32% in 1994 to 93% in 2007 . I don’t want to go into this too much more because it’s fairly well-discussed elsewhere.

Rajan’s other argument is more interesting: that the GSEs did not participate in the worst of the bust, but were responsible for setting it off. Adam Ozimek also supports this story, and offers an interesting image to describe it:

Thus, a signal which traditionally could be used to hold prices in check was gone, and the only signal market participants were left with was prices themselves. It’s as if someone turned out street lights and the only way drivers could navigate is by looking at each others headlights. It’s easy to see how this could lead everyone collectively far from the roads despite behaving rationally individually given the information available to them. This uncertainty and unanchoring of fundamentals set off the herd behavior that drove prices even higher, this lured private companies in who eventually crowd Fannie and Freddie out of the market.

That is — the initial purchases by Fannie and Freddie in the pre-boom years distorted market incentives and set off a bubble that the mortgage giants did not participate in themselves. This is a new and interesting story, but I don’t think we have a good enough understanding of bubbles in general to say that Fannie/Freddie set them off this time.

Check out, for instance, Markus Brunnermeier’s account of "bubbles" in the New Palgrave Dictionary of Economics. He’s one of the best guys doing research in this field. One of the things he points out is:

[W]e do not have many convincing models that explain when and why bubbles start

That’s partially because it’s unclear how to fit bubbles into a normal economic framework in the first place. But Brunnermeier tries anyway, coming up with a few models of how to think about this.

You could, for instance, have a “rational bubble” in which all participants recognize that the bubble will crash, but continue anyway because they believe that they can re-sell to someone else. However, rationality imposes some tough constraints on bubbles like these. You have to assume that the housing bubble would grow slower than the economy; because surely a housing bubble could never get so large that we are forced to substitute away from housing entirely. That seems to rule out the housing bubble. It’s also entirely unclear how government purchases of housing would set off one of these. Surely rational investors with rational expectations would recognize that the government's intervention would taper off as a bubble grew larger.

Alternately, you can introduce some behavioral biases. Fannie/Freddie could have introduced some “noise trading” into the world, causing some investors to mistakenly believe that prices are trending higher. The GSEs, in other words, could have acted like predatory momentum investors.

Yet Milton Friedman’s arguments against bubbles remains powerful. Why would investors not respond to the addition of crazy money by betting against the bubble? Sure, most investors can’t technically bet against housing, but home owners could choose to rent, there are REITs out there, etc. Why couldn’t rational trading eliminate the mispricing induced by government spending, assuming that the government did intervene in unprecedented amounts before 2002?

As Brunnermeier suggests, these are impossible questions to answer. The government now is clearly investing heavily in housing; yet no one fears that will spark a bubble. The government’s heavy investments in Financial firms, too, seem to have failed to cause a bubble there. In general, government investments in a field "X" don't spark bubbles. Generally -- if you're a free-market economist -- you believe that this simply results in crowding out of private money, which then goes elsewhere. If Rajan's account were true, on the other hand, I would probably be far more willing to support government intervention in general. Simply by investing a little too much, it can kick-start a bubble! Yet "kick-starting" and "jump-starting" private investments through an initial government push have been key priorities over the past two years, and I have no reason to believe any of that is working. So how is housing so different?

The state of the economics is just too limited to figure out the cause of any bubble, let alone finger any one entity as the cause of the housing bubble. Rajan's always interesting to read, and I would like it if Fannie/Freddie were implicated in the Housing bubble directly, as opposed to merely being ridiculously bad uses of taxpayer money. But I'll have to side with Krugman on this one.