Content Elsewhere

I thought I'd start linking to pieces I write elsewhere. Here's a backlog of recent articles:


Reuters (with Christopher Papagianis):

The growing clout of central banks

Election has big banks in crosshairs

More to the financial crisis than just subprime


National Review's The Agenda

Dartmouth Atlas vs. Teacher Salaries

Causes of Inequality

Household Wealth Comparisons

Cut Taxes for the Long-Run Unemployed

Counterfactuals and Country Comparisons

The Premium to Top Schools

Federal Lines of Credit

The Laffer Curve

Response to Saez-Piketty on Inequality

Saez and Diamond on Taxes

Joseph Doyle on High-Cost Hospitals and Health Care Reform

Rethinking Private Equity

Labor Supply and Taxes


Stanford's Policy Review (with Christopher Papagianis)

Making the Housing Market Work Again

Individualism and the State

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

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

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

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

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

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?

David Beckworth has channeled Gary Gorton to write:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Federal Reserve and Stagnating Wages

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

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

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

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

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

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

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

Delevering

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Where’s the Evidence for Deleveraging?

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

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

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

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

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

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

To Fix Bank of America: Rules not Discretion

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

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

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

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

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

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

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

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

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

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

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

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

Teaching Practical Math and English

From the New York Times,

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

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

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

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

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

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

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

Are Capital Markets Inherently Risky?

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

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

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

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

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

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

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

Female Labor Force Participation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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