John Cochrane's blog
U.S. SEC urges money funds to be prepared for tri-party repo defaultshttp://www.reuters.com/article/2013/07/22/sec-repo-guidance-idUSL1N0FS01B20130722
One thing you and your colleagues neglect to mention is there were real goods that served as the backing for the mortgage debt that banks were holding onto.
I think the most important message of this video is that financial system needs simple regulatory rules. It seems to me that Dodd-Frank does just the opposite. Dodd-Frank's regulatory prescriptions create additional loopholes for the Wall Street to exploit. These loopholes can only lead to new regulatory captures, like the ones from the Great Recession. In addition, I don't see how it would be possible to coordinate Dodd-Frank with other regulatory acts at the global level. Simple rules are much more easier to work with.
Vladimir,Before you can come up with rules, you need objectives. A simple rule would be banks are not permitted to lend money under any circumstances.
Franck,It is easier to tell what one should have done after the event occured than before. The problem is that politicians can change the rules at any time to meet their personal objectives which are not necessarily compatible with a strong stability of the economic system.
Frank,What is, by Your opinion, the most important objective of any economic system?I was thought, maybe wrongly, the only objective people have is to maximize the utility functions of their households. In doing so, they are constrained with different budgets, but they have common prior knowledge and rational expectations-rational in a sense they update their beliefs with newly acquired information. So, at least for me, the most important social objective of any economic system is to maximize the utilitarian welfare function! Having said that, the question becomes: What type of regulation enables that? Should we focus on noncoherent and inconsistent discretionary prescriptions of Dodd-Frank? Or, should we design rules so simple that cannot be misinterpreted by any economic agent? I would go with the second option. Regarding a simple rule You have proposed, I don't think it contributes to welfare maximization. It stops the matching of funds between people who have more money with the people who don't have it enough! And, that is why we have the financial system in the first place.
In my opinion, the most important economic policy objective of any fiscal / monetary policy regime is to maximize productivity."I was thought, maybe wrongly, the only objective people have is to maximize the utility functions of their households."Here you are talking about the individual / family's objective. That may but heads with an economic policy objective like productivity. For instance, unemployment benefits may assist a mother and father in maximizing their utility function (raising a family) but to the detriment of productivity."Regarding a simple rule You have proposed, I don't think it contributes to welfare maximization. It stops the matching of funds between people who have more money with the people who don't have it enough!"It stops the matching of funds between people who have an immediate demand for money with people who do not have an immediate demand for money.
I we would only listen to the economists... they study these things for a living!
Frank,I agree that productivity is important. However, I think about it as a tool for achieving higher growth and welfare. In other words, the only reason why we should care about productivity is because it leads to higher growth and welfare. Fiscal/monetary policy regime has less to do with productivity than growth promoting policies. The reason why we should care about growth promoting policies in the first place is because they are concerned with productivity boost! In order to do that they must answer the following 2 questions:1. What are the sources of growth?2. How to combine these sources most efficiently?The sources of growth primarily lie in ideas and innovations. The most efficient way to combine them is through competitive markets with a free flow of information, physical and human capital. The competitive markets must be founded on simple rules of the game known, and equal, to everyone ex ante. Everything else is just a crony capitalism!I don't have space to write about the rest of Your comment here. I will adress the issue in the next post. I just wanted to stress why productivity should be regarded as a mean, and not an objective of economic policies. I also hope I was clear what is the best way to boost it.
Vladamir,"However, I think about it as a tool for achieving higher growth and welfare. In other words, the only reason why we should care about productivity is because it leads to higher growth and welfare."I think about productivity as a measured result (similar to efficiency in mechanical / electrical systems). Imagine if productivity was defined as Real GDP per unit of debt. Does higher productivity guarantee higher growth? No it does not. It only means that the growth rate of the real economy (goods produced) is higher than the growth rate in credit expansion even though both may be contracting.Or if you prefer, imagine if output fueled by consumption is increasing because the housing bubble continued on? Why go out and work to produce new goods when I can just continue borrowing against the increasing value of my existing house and buy goods produced over seas? Would domestic productivity be increasing because output rises while labor hours fall?
Frank, I think Your analysis from is absolutely correct, if we agree that the real GDP per unit of debt is an appropriate measure of overall productivity. However, I have some concerns with it. Overall productivity is a measure of output per unit of inputs. Output is usually measured as real GDP. So, we agree about the numerator. Inputs include labor and capital and they are financed with debt and equity. So, I think the denominator must be a sum of total debt and total equity in the economy.
Vladimir,I choose to include debt alone because credit origination brings new money into existence where equity issuance does not.Where I am operating from is the equation of exchange:Money * Velocity = Price * Quantity = Real GDP * ( 1 + Inflation Rate )Replace Money (M) with Debt (D):Debt * Velocity = Real GDP * ( 1 + Inflation Rate )Productivity can be expressed as:Productivity = Real GDP / Debt = Velocity / ( 1 + Inflation Rate )If we treat the inflation rate as an exogenous variable we get:Inflation Rate = Velocity / Productivity - 1By this definition, productivity improves when corporations convert debt to equity. The reason is the differing incentives that bond holders and equity holders face. A bond holder has a higher degree of legal protection in the advent of losses. As such his / her incentives are not aligned with technological progress - he / she gets paid the same amount regardless of whether or not the company he lends to has built the better mouse trap.
Frank,I understand when You say that equity issuance does not create new money. In previous comment I just wanted to point out that the productivity measure with GDP in the numerator must take into account all sources of finance used in creating it. I see that this would complicate the algebra. I think the model is mathematically correct. However, I do not understand its economic implications. The model implies that productivity improves when corporations convert debt to equity, according to the first sentence of Your last passage. But, corporations do not have an incentive to issue more equity relative to debt, since the equity is more expensive. However, corporations have an incentive to maximize profits. And they can do so by minimizing the weighted average cost of capital. This type of behaviour explains observed high debt-to-equity ratios. I do not have a problem with corporations that decide to exploit the good old leverage effect. I have a problem with politicians that bail them out with taxpayers’ money when the leverage effect starts to work its magic. I think the problem arose when You equated money with debt. Money is just a form of short-term government debt. The Grumpy Economist taught me that in his conversation with Harald Uhlig on Morningstar. You can watch the conversation on this blog under a title „Unraveling the Mysteries of Money“. So, let’s take Your simple model and equate the money with its closest substitute, i.e. short-term government debt. I understand that this is a simplification of things, but I find it much more realistic than Your assumption. Productivity is then defined as a ratio of real GDP and short-term government debt. As long as the average real GDP growth rate exceeds the average real short-term interest rate, we are in business. In order to start growing faster, I would like to refer to a set of growth promoting policies that I mentioned earlier. For example, we can try to simplify the tax code. To shrink the size of government debt, I propose lower government spending for unproductive purposes. We would be much better of by shifting that money in research and development, for instance.Finally, I am afraid I’ll have to exit our little debate. Do not misunderstand me, I enjoyed enourmously. I am looking forward to future conversations on this blogspot. I like reading it very much. But, I have spent so much time on this topic, and I only wanted to say that I prefer economic policies founded on simple rules of the game. I have already neglected my girlfriend and she is not pretty happy with thatBest wishes, Frank!
Vladamir,"I think the problem arose when you equated money with debt. Money is just a form of short-term government debt."Not exactly. Money is a medium of exchange. The legal implications of money require that all members of an economic group (sovereign) agree that the money chosen will be accepted in all exchanges. Debt (even short term debt) is a two party contractual agreement. Money can be created as part of that two party contract and money can be destroyed when that contract is fulfilled. Our legal system enforces that two party contract."So, let’s take Your simple model and equate the money with its closest substitute, i.e. short-term government debt. I understand that this is a simplification of things, but I find it much more realistic than Your assumption."Short term government debt and money are not equivalent. Money can be created when the government borrows that money into existence and can be destroyed when tax revenue is used to extinguish that debt. Whether the government borrows short term or long term is irrelevant.In fairness to Mr. Uhlig, money and short term government debt have some similar properties - they are highly liquid, they do not bear default risk, etc. But that does not make them equivalent. Short term government debt (like all government debt) is a legal claim on future tax revenue. Money (currency) is not a legal claim on any thing."As long as the average real GDP growth rate exceeds the average real short-term interest rate, we are in business."Not exactly. As long as the tax revenue of the federal government is equal to or exceeds the interest expense of the federal debt, the federal government can roll over existing debt indefinitely. "Productivity is then defined as a ratio of real GDP and short-term government debt."No. See housing bubble. You may or not be aware that housing prices were once part of the consumer price index (pre 1983). And so Real GDP growth (as currently measured) can be misleading. You really need to look at all debt (public and private) to gauge productivity.The reason that federal government debt is a detriment to productivity is two fold - 1. The federal government does not exist to produce new goods (the federal government is not in the car building or apple growing business). And so government expenditures funded with debt tend to be inflationary because they are typically designed to boost consumption instead of production (unemployment benefits).2. The owners of the federal debt are guaranteed repayment by law. And so, the owners of the federal debt have little incentive to produce anything as well. "To shrink the size of government debt, I propose lower government spending for unproductive purposes. We would be much better of by shifting that money in research and development, for instance."To shrink the size of government debt, all that needs to happen is for the federal government to sell equity (non-guaranteed) claims on future tax revenue instead of debt (guaranteed) claims on future tax revenue.It was good to talk to you Vladamir. Hope to hear from you again soon!!
Vladamir,"I think the model is mathematically correct. However, I do not understand its economic implications. The model implies that productivity improves when corporations convert debt to equity, according to the first sentence of Your last passage. But, corporations do not have an incentive to issue more equity relative to debt, since the equity is more expensive."But corporations do have the incentive to be more productive when their funding is tilted toward equity issuance. Equity can be more expensive or less expensive than debt depending on monetary and fiscal policy stance. That incentive is forced upon the company by the holders of equity.
"Equity can be more expensive or less expensive than debt depending on monetary and fiscal policy stance."... Hmmm, look up "Modigliani Miller Theorem"
John,Modigliani Miller states that the value of the firm is independent of the means of finance (debt versus equity). Modigliani Miller is only applicable for monopoly enterprises where default risk is not a factor.http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theoremThe implicit assumption is that the debt taken out by a company is perpetual. The only way you get perpetual debt is by eliminating default risk. Sovereigns can issue perpetual debt, individuals and companies cannot.
Also,The deductibility of interest expense from taxable income is a fiscal policy stance.
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Vladimir,I sent you an email response to all of your questions with additional discussion to the following email address:firstname.lastname@example.orgGood to see your girl friend doesn't have too tight a strangle hold on you :-)
Frank,I saw an email. I appreciate it very much. I didn't have time to read it thoroughly. I will answer Your questions, at least those that I know the answer, in the next couple of days. I want to make several things crystal clear. First, when I said that I had enjoyed our debate I really meant so. I was not trying to be ironic or sneaky. Second, the reason why I wanted to exit the debate is because 99% of our comments has absolutely nothing to do with the video. It also took me a substantial amount of time and I have some important obligations in the next couple of weeks. For this, Frank, You owe me a bear! Third, when I cited the references I didn't mean to show off. I just wanted to document my claims. As a matter of fact, I will delete my comments as well. If Your answers are not public, my questions should not be as well. Once more, I apologize to professor Cochrane for not keeping it short.Best wishes, Frank!P.S.I was joking about the girlfriend. She loves economics as much as I do. Especially, finance. I wander is this love for finance is gender biased?:)
Frank, You talk about the collision of productivity and welfare as economic objectives. The unemployment benefits will increase the consumption, hence the utility, of the representative household receiving it. When I say representative household I mean the one that describes all households in the economy in a most appropriate way. That is true. But, the higher the unemployment benefits , the lower the incentives of people to work. The number of working hours goes down and the unemployment goes up! This is especially true if You analyze a dynamic multiperiod model of the economy. Lower number of working hours, along with the higher unemployment, impedes economic growth, but not necessarily labor productivity! Why? Because the labor productivity is usually defined as a ratio of output per hour worked or output per employed person. So, in a single period static model of the economy, growth, not productivity, and welfare might be in a collision. However, in the long-run, lower growth is always associated with lower welfare.Regarding Your last comment, I think we should focus on the rules that would eliminate potential market freezing, instead on straw man arguments.
Vladimir,"Lower number of working hours, along with the higher unemployment, impedes economic growth, but not necessarily labor productivity!"I am referring to broader economic productivity (Real GDP per unit of debt) not labor productivity in particular. I only gave the unemployment benefits as an example of how differing economic policy objectives can collide with each other.I never bought into measuring productivity as output per hour worked first because output (defined as nominal GDP) can be sustained through inflation of either goods or assets (equity, houses, etc.), second because labor is only one cost built into the production of goods, and third because units for things like total factor productivity are essentially meaningless.
Frank,I have used labor productivity as an example, since the labor productivity is directly influenced by unemployment benefits You have mentioned. I have stated my concerns with the real GDP per unit of debt as a productivity measure in a reply to Your previous comment.
Vladimir,Going back to the original question that started all of this:"What is, by Your opinion, the most important objective of any economic system?"Notice that I didn't really answer your question. My answer was this:"In my opinion, the most important economic policy objective of any fiscal / monetary policy regime is to maximize productivity."You asked about economic systems. I gave an answer about economic policy.Whether an economy grows or not under a "maximize productivity" economic policy regime is left completely up to the economic participants. If the members of the economy want it to grow, then it will grow. If they want it to contract, then it will contract. What ever happened to "Freedom to Choose"?
Frank,I agree completely.
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