Why we (still) need Cramdown

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

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

Not Enough Mods

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

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

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

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

Mods of the Wrong Type

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

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

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

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

Cramdown

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

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

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

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

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

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

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

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

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

Quantitative Easing

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

Should the Fed Ease Ever?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Should the Fed ease Now?

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

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


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

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

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


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

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


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

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

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

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

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

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

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

Why QE?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is the US More like Italy or Japan?

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

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

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

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

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

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

David Beckworth provides a graph for the US, here:

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

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

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

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

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

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

Do Taxes Matter?

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

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

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

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

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

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

Here’s another graph in support of that interpretation:

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

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

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

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

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

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

Rajan, the GSEs, and the Housing Bubble

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Elizabeth Warren and Credit Crunches

Mike Konczal takes exception to my post over at e21 on the impact of 2009 credit card reform. There, I tried to argue that restrictions on credit hurt consumers in several ways, and this will be worth bearing in mind as we get a new Consumer Protection Agency (potentially headed by Elizabeth Warren).

Konczal makes a number of points:

1) The law was going into effect anyway. He argues from a Reuters piece that the new law merely enforces changes that the Fed had already planned on.

This goes against everything I’ve read on the bill so far, and I can’t seem to find any other corroborating evidence. It looks like the Democrats made a previous attempt to pass the bill in the House, and succeeded, but it took until after the election to get legislation through both houses.

Certainly, this seems to be the general assumption among both liberals and conservatives at the time—that this is a sizable change to the status quo, and will affect credit cards (either in a good or bad way). For instance, the Reuters article goes on to tell us:

Banks have repeatedly warned higher interest rates are likely to result because it will be more difficult to set rates based on the risk that customers pose. The higher rates mean less credit available for consumers, they say…

Banks may also reduce credit limits, or make it harder to obtain card-affiliated rewards, Arnold said. And others may return to charging an annual fee, now charged by only one in five cards, he said.

All sorts of other media reports (for instance, see here and here) have argued this is an ongoing issue. None of this proves that the bill is to blame, of course. But everyone seems to regard the passage of the bill as a new thing, and plenty of people seem to think that banks did change their behavior afterwards in response to the bill’s passage. Even if the bill did nothing new--people only became aware of the consequences afterwards, that's when you expect to see a change.

2) Credit card rates aren’t rationally set anyway. The big piece of evidence here seems to be that credit card rates tend to rise quickly after you miss a payment (the bill really tackled this issue by making it much more difficult for companies to raise your rates arbitrarily).

I think commentor “Mike” raised a good point on this, that Mike (Konczal) also mentions in his initial post. One reason that companies are so quick to raise rates on delinquent card-owners is because it sends a strong signal about the future ability of borrowers to make payments. Perhaps I’ve hit a shock, or who knows what else. The easy thing to go is to call in that payment right away. Credit card companies don’t really have a chance to burrow into the full aspects of a consumer’s finances, and payment choices are the big piece of information they have to go on.

I think there are several parallels in other parts of finance. For instance, suppose I’m an Investment Bank with plenty of repos outstanding. The moment I hit a little bit of a rough patch—my creditors immediately come knocking and take away my funding (potentially making a crisis more likely). Gary Gorton has referred to this a transition when loans change from being information-insensitive to being information-sensitive—and I think there are some parallels here.

You can say that relying on short-term funding if you’re a bank (or credit cards if you’re a household) is a horrible idea, because it involves taking on credit that can withdraw so quickly. Generally, I would agree. But while banks have the option of opting for longer-term credit (and choose not to take it), often these sorts of unsecured loans are the only way people have to cope with unexpected shocks (including medical charges, as Mike refers us to).

Now, it’s perhaps true that the degree of price hiking is greater than a simple model would predict. This no doubt reflects some degree of borrower inattention combined with creditor market power. But it’s consistent with credit card companies adopting a broadly rational pricing structure, which will respond within broader legal constraints. A monopolist may charge outrageous prices to begin with, but will still raise them when taxes rise.

So think of what it does for a simple credit card financing model. In the past, companies could tell apart good and bad risk individuals, based on their pattern of delinquencies, and charge higher rates to the high risk folks. Now, they have to charge rates uniformly across the pools. It doesn’t take extreme rationality assumptions to think that banks will now raise rates on both groups, to recoup the lost profits from discrimination. This is, again, what news report after news report argues to be the case.

Now, if Konczal wants to argue that a more egalitarian approach to credit risk is preferable, and the impacts of the law are good—I think that’s a perfectly defensible position to take. Though I’m inclined to favor Matt Yglesias’ point that it’s better to let competitive businesses charge as they like and make up for distributional effects through the tax code. The particular timing of the law—taking effect as it did in the middle of a huge downturn—is potentially another large concern. Given the importance of revolving credit for the payments system, the bill plausibly had a contractionary effect by discouraging spending in general. This really was the point I was trying to make: not that the law was "bad" (though I think that is the case); but that it involved a set of tradeoffs that people didn't quite realize.

3) Other things are to blame. I’ll be the first to agree that many things are going on here (of course, if one believes that higher credit card defaults result in higher rates, you probably believe that rates are being set in some sort of reasonable fashion). What drew my eye here was the fact that rates were completely flat before the law, and only took off after the bill passed, while presumably card delinquencies were rising throughout the period. Auto loans probably had a spike in defaults as well, and also did not receive any assistance from the Fed, while seeing stagnant rates. Of course, this graph is merely suggestive rather than causal in nature.
But I also mentioned other evidence Konczal doesn’t touch. From the mouth of JP Morgan’s CEO:

In the future, we no longer will be offering credit cards to approximately 15% of the customers to whom we currently offer them. This is mostly because we deem them too risky in light of new regulations restricting our ability to make adjustments over time as the client’s risk profile changes.

We reduced limits on credit lines, and we canceled credit cards for customers who had not done business with us over an extended period.

In fact, the industry as a whole reduced limits from a peak of $4.7 trillion to $3.3 trillion. While we believe this was proper action to protect both consumers and card issuers, doing so in the midst of a recession did reduce a source of liquidity for some people.

I don't put too much stock on the self-serving arguments of executives, especially ones that work for JP Morgan, but it's certainly suggestive. And though I did not post on this, there is certainly information out there backing up the idea that credit limits plunged during this time period—again, with a pattern around the date of the bill’s passage.

Figuring out the effects of law changes is tough. Warren suggests how we can do so without being ideologues:

I finally filled in the blanks, suggesting some empirical tests–ticket prices for companies that do/don’t use such clauses, changes in pricing before/after such clauses are used, evaulation of whether cost is large enough to be reflected in price, etc.

I think my analysis so far has focused on exactly these sorts of tests, noting that I have limited information and other things are going on. Konczal, of course, has responded with little new data of his own.

Obama Will be a One Term President

According to Bernanke's testimony today:

"The unemployment rate is expected to decline to between 7 and 7-1/2 percent by the end of 2012."

By the way, this is roughly the same unemployment rate as in 1992, when Bush won 38% of the vote, and that too after the Gulf War. It's very difficult to win elections when unemployment is that high.

If I were a Democrat at the hearings, I would push Bernanke on this issue, as their electoral futures depend on his actions. If I were a Republican, I would also push Bernanke--because unemployment this bad will create pressure for all sorts of additional government intervention on the fiscal side.

What is the Free Market solution?

David Frum thinks that Krugman is wrong about government spending as a solution to our problems. But what, then, is the free market solution? Cutting unemployment benefits? What about cutting taxes--even though we tried lots of that in the 2000s, without apparent success?

First of all--you can easily turn the last issue. How can government spending be the way out of our mess if we tried lots of government spending for the last ten years without getting good results either?

But more seriously--yes, there are plenty of free-market solutions for dealing with the really very bad consequences of a serious deflationary recession:

1. Wage subsidies: I've argued how to make them work here. Basically, we have unemployment because workers are less productive during bad times, yet employers can't pay them any less because wages don't tend to move down. What we can do, instead, is keep paying workers the same amount, but let employers pay less, by having the government pick up the difference. A simple payroll tax cut should do it. As the cost of hiring goes down, companies now hire more. Singapore and other European countries have tried these policies to an extent, and they seem to work pretty well.

2. Speed Bankruptcy: The aftermath of financial crises are very difficult times because of the buildup of toxic assets which stay on firm balance sheets. It is possible to wipe those out through bankruptcy, and let firms begin lending again. I describe this a bit here. This way, you don't have as many so-called balance sheet problems, and can start with a clean slate.

3. Better Monetary Policy: I'll just refer you over to Scott Sumner's blog, where he has been arguing for some time now that looser monetary policy now could dramatically boost the economy, without incurring deficits.

4. Get Capitalists to Act like Capitalists: I go into this a bit here. Basically, instead of thinking that we need to get the government to buy up all sorts of "stuff"; we should come up with targeted ways to boost the value of business assets and investments. We can tweak the tax code to do this; and the LibDem-Tory government in England is planning on doing so, even as they enact austerity cuts.

I'll grant that there are a lot of divisions among even free-market conservatives on these issues. Raghuram Rajan, for instance, would like to tighten monetary policy and make labor markets more rigid. I happen to think he's mistaken on those issues, as a similar set of policies created the Great Depression. But it shows the diversity of thought among right-center thinkers. There are options other than "spend government money."

In fact, if anything, I'd say that it's liberals who don't have a great plan for getting out of these messes. Even if austerity is a bad idea, Keynesian spending has never really lifted a country out of a bad situation. Not for Nazi Germany, not America in the Great Depression, not for Japan. Of course, it was Krugman himself who pointed out how futile Japan's attempts at expansionary fiscal policy in the '90s, and how they should switch to a monetary stimulus.

And of course, large gobs of spending doesn't work at all unless you are America--a country facing large problems, but low interest rates. Other European countries are looking at austerity measures not because they are insane, but because some of them are actually facing bond vigilantes.

The only thing I can conclude from Frum's question is that he pays no attention to free market economists at all. People like Alex Tabarrok and Edmund Phelps have argued for wage subsidies; Milton Friedman and Scott Sumner for better monetary policy in large recessions; folks like Garret Jones have argued for speed bankruptcy; and so forth. These are all very libertarian-minded people. Has Frum really never cracked open Milton Friedman?

Bankruptcy is Always an Option

I’m very sympathetic to Mike Konczal’s argument against bankruptcy as an option for winding down systematically important financial institutions. We tried bankruptcy for Lehman Brothers, and the consequences were pretty bad (no matter what John Cochrane says). I think it’s pretty clear that bankruptcy, as it exists today, is unsuited for large financial institutions, as they exist today.

Still, I’ve slowly come to the conclusion that a prepackaged form of bankruptcy, under FDIC auspices, has a lot of advantages. It would require some tinkering with the Bankruptcy Code and how financial firms work; but has the advantage of moving us to a world in which financial firms can fail, discharge liabilities in an orderly fashion, and open their doors the next day.

We have some precedent for this, by the way. When WaMu failed; the FDIC stepped in; wiped out shareholders, and sold off the bank to JP Morgan without hurting grandma's deposits. And if you look at the canonical treatments of this issue in corporate finance--it's clear what to do. When firms become insolvent, you need to write down debt and give debt-owners equity ownership.

Here’s how this sort of framework would work—I’m working through proposals advanced by Garrett Jones, Wilson Erving, and Paul Calello. When a firm signs up for bankruptcy; regulators would come in and start by immediately writing off all equity and marking down assets. Then, the bank is recapitalized by writing off junior debt, and then as much senior debt as required, and converting these into equity. Basically, we would by fiat say that all bank debt is really convertible capital, triggered by bankruptcy.

To take a concrete example--let's work through Bank of America's latest 10-Q. I suspect they are insolvent now anyway, as are many large banks--more on this later. You'll see ~2.3 trillion in assets. On the liability side, you have ~1 trillion in deposits, ~500 billion in long-term debt, and about 600 billion in other liabilities. The stocks are worth about 230 billion.

Let's say BofA runs into some trouble, and their shareholder equity (stocks) plummets to ~75 billion. For fun, let's say that they have about the same in losses. They enter bankruptcy. All a judge has to do is say--write down that equity! Those stocks are now worthless. Next, we'll wipe down, say, half of that long-term debt and turn it into equity in the new company. If that's not enough, we'll go after the other liabilities or more debt. We can go after subordinated debt harder than we hit senior debt.

That's it. Bank of America opens the next day having written down large portions of their toxic loans, and is recapitalized by their long-term lenders. We can now sell this entity off to whoever wants it, or they can stick around and make new loans. Grandma keeps her savings account as well--though, in a perfect world, I'd take a haircut of that too if grandma has more than, say, $50,000 saved in FDIC institutions overall.

This proposal manages to do everything we want bankruptcy to do, while tailoring the response for financial institutions. In bankruptcy, we recognize that firms have failed, and kick out old management. Lenders take haircuts in order of seniority, but do better in bankruptcy than in liquidation. Meanwhile, these firms—now recapitalized, and without toxic assets—are free to raise further capital and lend.

When opting for a hybrid bankruptcy route, however, it’s also essential to reform the bankruptcy code to end derivative counterparties’ exemption from the automatic stay preventing collateral seizure in bankruptcy. As both Chris Papagianis at e21 and Mike Konczal have noted, this exemption reduces the incentive for the suppliers of short-term capital to shadow banks to monitor their risk-taking.

To draw an analogy; the Asian financial crisis in 1998 was sparked by the flight of short-term foreign capital, much as the Financial Crisis of 2008 was sparked by the flight of short-term repos from Investment Banks. In the Asian crisis, foreign creditors chose a short-term financing structure because that gave them an easy avenue of exit when things went south. Similarly, repo lending and derivatives took off because these contracts would not be subject to the same considerations as other contracts in the bankruptcy process. The best way to curb a risky reliance on short-term lending is to force these contracts to be treated like others in an orderly bankruptcy process.

Finally--spinning off prop trading desks and derivative dealer operations--which should be happening to a degree under the new Financial Reform bill, should probably make this easier as well. We really want our financial firms to focus on underwriting securities offerings and extending loans throughout the financial system. It's easier to work through the bankruptcy of a bank, rather than the bankruptcy of a bank which also owns a casino.

Dealing with financial companies in some manner like this is incredibly important for three reasons:

1. We finally get to make lenders pay. For instance, here is Russ Roberts:

There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks. Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.

Well, those bondholders and lenders made plenty of money on the way up, taking risks. They need to bear those risks on the way down, instead of taxpayers. Then, maybe they will do a better job of monitoring the risk going on in financial institutions.

Lenders really are the optimal agent to handle bank monitoring, by the way. Regulators are prone to cognitive biases and regulatory capture when times are good. Owning stock in a highly levered institutions is akin to holding an option, and makes you really want to ramp up risk. Managers of firms are paid in stocks, and so also have a strong risk preferences. It's really the bondholders and depositors--who make money as long as things don't go really bad--who have the strongest incentives to watch what's going on in terms of risk-taking. But this won't happen if they get bailed out, or can handle their contracts through repos and derivatives.

2. Two is the zombie banking problem. As Anil Kashyap and others have shown, the refusal to accept banking sector losses in Japan led to a decade-long problem of “zombie banking” in which fundamentally insolvent banks lingered, without funding new investment. Saddled with liabilities, American banks are not lending. Rogoff and Reinhart, among others, have suggested that this is a large part of why recoveries from financial crises are so anemic. The Administration has argued this as well. Yet, incredibly, no one actually seems to have an idea for dealing with this debt. This was Michele Boldrin's point in his debate with Brad DeLong. It's not at all obvious that Keynesian stimulus is a valid substitute for a serious push to deal with bad debts.

2. Third is the problem of soft budget constraints. This is a concept invented by Janos Kornai initially to examine the sources of inefficiency in Communist governments. Kornai had the insight that when firms expect to be bailed out after taking large losses, they alter their behavior.
However, this logic also holds in capitalist economies for all entities—be they hospitals, government-backed mortgage giants, or large banks (or car companies, large insurance companies, airlines, money-markets, sub-national states, European countries, etc.)—that expect fiscal assistance after chronic failure. Financial institutions armed with a Too-Big-to-Fail guarantee are virtually certain to make risky investments that generate current income, with long-term costs borne by the taxpayer.

To a certain extent, the last two problems balance each other out the way our system works now. Banks may be more reluctant to lend if they retain toxic assets on their books, but may be more willing to lend if they expect to be bailed out. This is perhaps the intention of policymakers, who are eager to find ways to increase lending without forcing banks to recognize the true nature of their losses.

This is perhaps why the American response represents a substantial improvement relative to Japan. But as long as these problems remain intact, lending will remain at a knives edge caught between two politically mandated and unpleasant alternatives. It’s clear that the bailout route is a very second-best way to address problems within the banking sector, and It’s important to develop techniques for the unwinding of systemically important financial institutions that avoid creating banks that behave like those in Japan or the Soviet Union.

I don't want to exaggerate the differences between this framework and the newly-created resolution authority. As I understand it; under resolution authority, banks enter federal receivership and their books are sorted out by regulators. The process, then, resembles bankruptcy in certain respects. The big change I'd make here is simply a mandatory haircut of debt before taxpayers contribute a dime, or else mandatory convertible capital requirements triggered when resolution kicks in.

I'm sure this solution has lots of problems as well. But it's not obvious that these problems are worse than the ones we already have. And you only need to write a few pages of legislation to get here.

Rajan is wrong: Interest Rates are not Low

I’m very reluctant to criticize Raghuram Rajan, as he’s been a careful and brilliant economist over the years who has voiced prescient warnings about our current financial crisis.

But he’s been lately arguing some odd ideas unsupported by very much evidence. In his latest piece, he argues that currently lax monetary policy is a durable threat to the economy. Low interest rates encourage borrowers to take on risky and speculative investments, while piling on debt.

Scott Sumner takes down this argument fairly effectively. But there is another reason it’s wrong—interest rates aren’t low.

Check out this graph from Robert Hall:



















The chart shows interest rates on various forms of investments. Ideally, once the recession began, we should observe that looser monetary policy (or other stimulus measures) should work to reduce interest rates across all asset categories—this is, after all, what Rajan and others argue happened when interest rates were too low from 2002-2004.

Instead, monetary stimulus has had a limited effect on interest rates. You see lower rates in Treasury bills (where the Fed has indeed purchased many T bills as a part of conventional policy), as well as for mortgage-backed assets (where the Fed has purchased over a trillion dollars of GSE-insured assets). But you don't see it in other asset categories.

In fact, government policy is pushing in the opposite direction in the case of credit cards. In the first part of 2009, interest rates on credit cards shot up. This is directly attributable to credit card legislation which made it much more difficult for credit card companies to adjust rates in the future. Unsurprisingly, they all raised rates immediately while cutting credit lines—sparking a credit crunch which made the recovery much harder. Thank you, Elizabeth Warren.

It’s unclear why monetary policy is doing so poorly in this case. Presumably, problems in the financial system are clogging the system, so to speak, limiting the ability of stimulus measures to impact the real economy. A big part of this is probably due to the Fed’s decision to start paying out interest on bank reserves in 2008. In a single stroke, the Fed managed to devastate the monetary base by converting non-interest bearing reserves—which are interchangable with currency—into an interest bearing security. This massively tightened monetary policy in a critical period; has made measures of the monetary base unreliable as estimates of the stance of monetary policy; and has made banks entirely unwilling to lend money as long as they have the option of keeping it at the Fed.

So we need very different monetary policy. Aside from changing the policy of paying out interest to banks to charging banks for the money they store as reserves--one option would be to alter the Fed’s charter to allow it to engage in more robust monetary policy. As far as I know—the Fed can only purchase assets under government guarantee (ie, Treasury bills and GSE-insured assets). It would be simple enough to allow the Fed to also purchase all sorts of assets as long as they are under a credit default guarantee. This would dramatically improve the ability of the Fed to alter monetary policy, completely eliminate any need for fiscal stimulus, and finally lower interest rates. And then Rajan’s complaints would at least respond to ongoing events.

Wage Subsidies

Short Version: Cut payroll taxes!

Long Version:

America is almost certainly facing a period of persistently large unemployment. Nearly 15 million people are currently unemployed, while the CBO projects that the unemployment rate will not drop to eight percent until 2012, a rate more typical of a recession.

Broader measures of unemployment paint an even worse picture. A substantial portion of the unemployed workforce are not simply between jobs, but are facing a prolonged jobless period—including six million who have been out of the labor force for more than six months. A broader measure of underemployment accounting for discouraged workers who have stopped looking for work or can’t find full time work is above sixteen percent.

The recovery, then, will in all probability be jobless. Economists Carmen Reinhart and Kenneth Rogoff suggest that countries in the aftermath of systemic banking crises face stagnant output and employment growth. This may be due in large part to the unwillingness of financial institutions facing broken balance sheets to extend lending. TARP successfully recapitalized larger financial institutions, but it did not help smaller banks that are the dominant source of funding for small and medium sized businesses. A NFIB survey of small businesses found that regular borrowers had the greatest difficulty in finding credit since 1983. While few small businesses reported financing as their biggest problem, credit constraints may inhibit small businesses from creating jobs in the recovery stage—as they have in previous downturns.

Households, too, face balance sheet problems. Steadily rising home appreciation provided the impetus for debt-fueled growth in consumption over the past decade. Now, households are more inclined to save—a good long-term strategy, but bad for jobs in the short-run.
And with interest rates close to zero, the Federal Reserve is unable to easily boost growth through conventional monetary policy. More unconventional monetary policies like quantitative easing or NGDP targeting are not being seriously considered by the Federal Reserve. Ben Bernanke’s academic work (which earned him his present job) on the Japanese experience with the zero-rate bound emphasized exactly these policy responses, yet he has repeatedly removed these from the table.

Even robust economic recovery on its own may be insufficient to restore employment to pre-crisis levels in the near future. In the past, economic growth was strongly correlated with employment generation—a statistical relation known as Orkun’s law. This dynamic held during the steep drop in output and employment during 2008. Yet it has broken down for the recovery. The CEA, for instance, found that unemployment in the fourth quarter of 2009 was 1.7 percentage points higher than historical data would suggest. Even as the economy has resumed positive growth, the Administration projects that the economy will generate less than 100,00 jobs per month throughout 2010.

In the past, wage entrenchment was a driver of employment growth during economic recoveries. Inflation eroded real wages, encouraging employers to start hiring. Higher dollar wages encouraged workers to rejoin the labor force, even though these jobs paid less in purchasing power. Ben Bernanke found this process of wage adjustment through inflation to be a powerful global driver of employment generation after the Great Depression.

Estonia saw a huge economic drop after the crash, but has also seen a large readjustment in prices and wages. This price realignment was difficult, but has paved the way for recovery.
Yet dollar inflation is today close to zero, preventing wages from naturally adjusting. Forecasters and prediction markets agree that this will continue for the foreseeable future, much as Japan’s financial collapse was followed by over a decade of stagnant prices. Without inflation, the only way to maintain full employment in the future would be for nominal wages to fall. Yet wages are “sticky” and typically only readjust upward. Meanwhile, as Casey Mulligan has noted, policymakers have introduced a number of different work disincentives, like longer unemployment benefits, a higher minimum wage, and mortgage modification efforts. The result is a deflationary overhang that will depress job creation for years.

So what? Today’s unemployment levels merely move America towards a level typical of certain European democracies. But America has not seen a prolonged period of unemployment this severe since the Great Depression.
A recent Atlantic cover article noted a number of psychological, social, and economic consequences of persistent joblessness. Being out of the job market takes a heavy personal toll on measures of mental health by separating people from the institutional moorings of a stable job. Recent graduates facing a weak job market can expect lower compensation over a lifetime.

The potential impacts on family formation are also worrying. As James Julius Wilson observed, women prefer not to marry unemployed men, but do not forsake having children—leading to single family households and an inter-generational cycle of poverty. The relatively low national unemployment rates in the past have disguised substantial concentrations of unemployment. In inner cities, Appalachian communities, and among lower-income families more generally—male employment has plummeted while single motherhood has risen.

America has not seen labor force participation rates this low among prime-age men for decades. Just as the housing bust has seen habits previously excluded to subprime borrowers (like high patterns of delinquency on mortgage debt) spread to more people; a prolonged economic downturn will have the effect of pushing the employment and accompanying social problems previously limited to low-income workers across a much bigger cluster of individuals.

There are structural problems with the economy which make unemployment an especially tough problem today, and which will probably continue to change the structure of unemployment in future recessions.

First, the level of unemployment varies substantially across levels of education. The unemployment rate among those with a college education has leveled off at 5%. Yet for those without a high school education, it is over 15%. Many workers simply lack essential skills, and will find it difficult to adapt to the restructuring in skill demand that has evolved over the course of the recession. As Mike Mandel has pointed out, the recovery out of the 2001 recession was intensive in real estate and residential construction, which was a boon for low-skilled workers. In contrast, the recovery so far has been dominated by hi-tech sectors like Internet publishing and search, and communications. The skills mismatch between the abilities that low-skilled workers have, and the structural shift in job composition, will make it difficult for any sort of economy recovery to reduce unemployment among many groups of workers.

Second, there are also substantial geographic mismatches, made worse by housing price declines. Haya El Nasser notes that the migration rate last year was the lowest since 1948, and this year is only slightly higher. Most worryingly, the percent of moves that cross county or state lines has dropped. Less than 13% of moves cross state lines, compared to almost 19% in 2004. Many moves are simply people moving out of foreclosed homes into nearby rentals. Many workers are “underwater” and owe more money on their home than it is worth—an amazing 70% in Nevada. This deters people from leaving Nevada—unemployment rate 13.4%—to, say, North Dakota (unemployment rate 4%).

The low level of migration and high level of variation in unemployment across states mean that even robust recovery across large parts of the country would leave behind large classes of workers. Workers will be unable to move in response to changing opportunities around the country. Even substantial recovery across a broad swath of the country may leave behind substantial geographic clusters. Those states which were experiencing difficulties even before the recession will now face even more catastrophic problems.

The Democrat response has been to pass a fiscal stimulus comprising tax cuts, spending on infrastructure and other projects, and fiscal relief to the states. Many progressives emphasize a second such stimulus to tackle unemployment. Yet even if one accepts estimates of these programs’ effectiveness, it is clear that many of these projects are extremely cost-ineffective at generating new jobs. Felix Salmon for instance estimates that it costs the government $300,000 to create every infrastructure job.

Government-led initiatives to boost clean energy, physical infrastructure such as high-speed trains or social projects such as education and healthcare may well be superb ideas on their own. But all are intensive in capital and specialized human capital. They will generate comparatively little employment for the low-skilled workers most affected by the downturn. Such forms of public works may have worked in the ‘30s, when “labor” was a skill-undifferentiated amorphous category. Today’s economy demands highly specialized human capital for the jobs favored in the stimulus—healthcare, education, energy—and so will be relatively poor means of generating mass employment.

The scale of fiscal stimulus and government subsidized industrial policy required to seriously tackle the long-run unemployment problem would be staggering and politically impossible in today’s environment. Concerns about America’s debt capacity have dominated discussions over the role of direct government spending in reviving employment. Yet even if the government was assured low interest rates for an extended period of time, it’s not obvious that more fiscal stimulus is the first-best way to expand employment.

Traditional conservative ideas, too, are lacking. The stimulus checks sent in 2008 were largely saved, as were the tax cuts that were a part of the ARRA bill. Policy interventions in the past year such as the minimum wage hike and greater unemployment insurance may have reduced the willingness of businesses to hire and employees to seek work to an extent; but repealing them would hardly be a sufficient boost to employment. The scale and degree of today’s employment problem demand new solutions.

The academic consensus on the problems of long-term unemployment and underemployment centers on the role of education. Rising wages from the 1950s to the 1960s were accompanied by a corresponding growth in educational attainment across all levels. Stagnating wages since that period have been similarly matched with a decline in the rate at which Americans gain education. This fall-off has been masked by rising GED enrollments. As Economist James Heckman observes, GED graduates behave and earn like high school dropouts rather than high school graduates.

Persistent unemployment is concentrated among the lesser educated. The housing bubble disguised the worsening job situation for unskilled workers through an unsustainable increase in the demand for construction. These jobs are gone and are not coming back. Manufacturing similarly has seen a long-term secular decline in workers employed—even as manufacturing output has grown.

Yet even rapid improvements in educational attainment—which would in any case be difficult to achieve—it would do little for today’s workers. Programs designed to improve the educational level of adult workers—like the GED program and other job training programs—have an abysmal track record—in part due to the fact that education comprises not only cognitive fluency, but also the attainment of certain psychological and non-cognitive skills difficult to build after adolescence. While improving educational attainment should remain an important long-term goal, it remains a too-distant option for those presently unemployed.

A more timely solution comes in the form of wage subsidies, an idea widely popularized by Economist Edmund Phelps. Unemployment happens when employers are willing to pay workers less than the amount workers demand. Wage subsidies bridge that gap by offering a government stipend to those willing to work. Effectively, a wage subsidy replicates the wage entrenchment necessary for businesses to hire again in lieu of inflation; while ensuring that workers can continue consuming.

The precise operation of that stipend can vary. A negative income tax, which provides workers a subsidy in negative relation to their earnings, would effectively subsidize work. A payroll tax cut would also have many features of a wage subsidy.

Wage subsidies in various forms have worked remarkably well in this last recession across a range of countries—in particular, in many European countries more typically known for sclerotic labor markets. In Germany, the Kuzarbeit, has offset the pay for workers facing lower hours. The Netherlands has a similar program of subsidizing workers in struggling firms. Singapore has seen enormous swings in its GDP during the crisis, yet has maintain an unemployment level in the mid-single digits—in large part due to its wage subsidies. Overall, 16 out of the 29 countries in the OECD have cut payroll taxes—mostly in Europe.

As a result, many European countries have kept employment losses far lower than America at a far lower fiscal cost. The 2009 ARRA bill, as a percent of GDP, was one of the largest fiscal stimulus in among developed countries. Yet the United States has also seen one of the greatest increases in unemployment.

However, while wage subsidies are ideal and usually prescribed during times of recession, their unemployment-busting powers make it ideally suited to dealing with the coming period of persistent joblessness.

While more direct wage subsidy programs like those common in Europe are absent from American policy evaluation, the CBO has evaluated a number of different tax credit policies. Along with increasing aid to the unemployed, the CBO found that reducing employers’ payroll taxes was the most effective and immediate job creation strategy. The EPI has estimated that a job creation tax credit could generate 5.1 million jobs over the next two years, at a cost of $27 billion.

The costs of such a targeted employment program need to be weighed against the enormous benefits resulting from fuller employment. Measured relative to other stimulus projects, a wage subsidy is a far more cost-effective way to curb unemployment.

Even if growth and employment growth unexpectedly resumed, this is a flexible policy that can be easily cut or expanded to respond to overall conditions. The downward tail risk of a ‘W’ shaped recession, or second downward bust—say by unexpected Chinese recession, or Euro collapse, or renewed economic problems stemming from the housing market—demand a flexible policy response that no current set of policy tools can provide.

A common critique of wage subsidies is that they cannot work because firms are cutting back because of falling demand, rather than worker compensation; or that they are simply uninterested in hiring unskilled workers. Yet millions of jobs were created even during the worst economic times, and many more firms were at the margin between choosing to hire or not; or choosing to fire or not. For instance, labor market guru Robert Hall argues the following:

The important feature that controls the job-finding rate is the incentives to employers to create jobs. At any given time, if the incentives are not very strong—it could happen for many different reasons—then employers will do relatively little to try to recruit workers. Job seekers will then have trouble finding jobs, will see themselves at the end of a long line of people waiting for the job....

So that’s the first thing to think about: job creation incentives.

Firm hiring decisions may radically change if companies faced a different structure for compensation. Even unskilled workers have some value to companies, and more would be hired if it were cheaper to do so.

There should be room for a bipartisan compromise on job creation. Progressive goals involving redistribution will be difficult to sustain politically if fellow feeling and solidarity are shaken by chronic economic insecurity. This loss of faith will also hit private institutions like marriage—a fact that ought to be of great interest to conservatives. If political elites fail to develop tactics to tackle the greatest period of economic chaos since the Great Depression, populism could make a comeback—with disturbing implications for trade and immigration policy. Recently, a group of economists of all stripes wrote a letter advocating wage subsidies. Hopefully politicians will follow.