Is Industrial Policy a good idea?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.