For More Corporate Raiders

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

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

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

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

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

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

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

Energy Prices

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

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

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

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

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

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

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

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

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

Were Mellon and Hoover Liquidationists?

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

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

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

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

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

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

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

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

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

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

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

Are Democrats or Republicans better for the Economy?

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

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

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

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

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

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

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

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

Bubbles and Unemployment

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

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

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

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



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

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

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

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

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

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

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

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

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

Is Industrial Policy a good idea?

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

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

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

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

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

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

Bankruptcy Reform and Financial Crises

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

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

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

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

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

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

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

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

Revisionism on Deposit Insurance

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

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

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

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

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

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

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

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

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

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

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

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

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

Prometheus and Education

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

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

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

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

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

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

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

The Savings Glut

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

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

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

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

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

Scott Winship and Inequality

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

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

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

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

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

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

Teacher Incentives Don't Work

From Roland Fryer's new paper:

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

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

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

Sticky Budgets and Inflation

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

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

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

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

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

Irrationality in Action

From the NYT's profile on Chris Christie:

When he was a federal prosecutor, Christie told the audience, he got to choose from about 100 health-insurance plans, ranging from cheap to quite expensive. But as soon as he became governor, the “benefits lady” told him he had only three state plans from which to choose, Goldilocks-style; one was great, one was modestly generous and one was rather miserly. And any of the three would cost him exactly 1.5 percent of his salary.

“ ‘You’re telling me,’ ” Christie said he told the woman, feigning befuddlement, “ ‘that no matter which one I pick, the good one or the O.K. one or the bad one, I’m going to pay 1½ percent of my salary?’ And she said, ‘Yes.’

“And I said, ‘Then everyone picks the really good one, right?’ And she said, ‘Ninety-six percent of state employees pick the really good one.’

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

Sweden's Socialist Republic of Children

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

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

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

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

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

Another person adds:

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

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