The Grumpy Economist

To London

2012-03-09T21:00:00.000-06:00

I'll be at the Booth campus in London next Monday March 12 as part of a panel discussion with Francesco Garzzarelli and Charles Goodhart on "Financial Stability and the Macroeconomy," sponsored by the Becker-Friedman Institute. More information on the event here. Presuming, of course, that the fact that Greece has finally defaulted doesn't mean the end of the world, as so many predicted. Ex-students, colleagues, and blog readers, if you come to the event, stop and say hi.

Too big not to fail

2012-03-06T15:21:00.004-06:00

The Economist has a great article, "Too big not to fail" about the Dodd-Frank regulation. Readers of this blog will know I'm no big fan of Dodd-Frank, for example an article in Regulation, collected opeds, and collected blog posts on reform. I've made most of these points before. But to hear it from the liberal-leaning Economist, with very detailed documentation, is good news.

A few delicious quotes:

The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.” ...

Take the transformation of 11 pages of Dodd-Frank into the so-called “Volcker rule”, .... In November four of the five federal agencies charged with enacting this rule jointly put forward a 298-page proposal which is, in the words of a banker publicly supportive of Dodd-Frank, “unintelligible any way you read it”. It includes 383 explicit questions for firms which, if read closely, break down into 1,420 subquestions, according to Davis Polk, a law firm.

And each subquestion presages another rule in the final version.

This is an important point. Most laws are laws. Most of the actual pages of Dodd-Frank are just directives for agencies to write the actual rules.

More importantly, it's not just explicit rules:

But the really big issue ...Officials are being given the power to regulate more intrusively and to make arbitrary or capricious rulings. The lack of clarity which follows from the sheer complexity of the scheme will sometimes, perhaps often, provide cover for such capriciousness.

For example, the new CFPB will have latitude to determine what type of financial products can be provided to which consumers and at what cost, as well as the right to pursue institutions for acting in an “abusive” fashion (a term with no legal definition). Requirements for “living wills” that encompass hypothetical business plans have to be pored over by regulators; “stress tests” insert government assumptions deep into the decisions banks make about their capital. ... the befuddling form the act gives such ideas unintentionally opens a path to much more state interference.

That's putting it mildly. Dodd-Frank is really not about rules at all. It just gives regulators power to decide what you do and how you do it. And it's going to be awfully hard for even the best intentioned regulator not to slide in to protecting from competition the business he's regulating (they are "systemically important" after all), or merging goals ("Nice bank you got there. If you were foreclosing a bit slower we sure could help a bit on consumer financial protection approval of that new credit card.") Or, as the Economist puts it,

Loans that might not fit into a category favoured by regulators are being trimmed or withdrawn.

..some well established banks consider themselves better able to handle the costs than smaller or newer ones, particularly those that don’t have cushy relationships with regulators.

Mission creep:

....a provision in Dodd-Frank concerning the extraction of minerals from in and around the Congo will mean that they [manfuacturers] will have to begin filing information on their entire supply chain to the SEC. This is officially estimated to affect 1,000-5,000 companies at a cost of $71m. The US Chamber of Commerce thinks it will affect hundreds of thousands. The National Association of Manufacturers estimates it will cost $9 billion-16 billion. Conflict minerals are a disturbing issue. They were not one of the causes of the global financial crisis....

Even Dodd-Frank’s creators can bring no similar clarity to its intentions. In 2009 Mr Frank attempted to frame the new law’s goals under four heads: securitisation, compensation, liquidation and systemic risk. But in a single speech his ambitions overflowed to consumer protection and the reform of ratings agencies, too. Ambition is often welcome; but in this case it is leaving the roots of the financial crisis under-addressed—and more or less everything else in finance overwhelmed.

This point really nails the fundamental flaw of Dodd-Frank. It never really thought about what the most important core problems were, and how to fix them. Instead, it basically thinks we didn't have "enough" regulation, so proceeds to "regulate" more, and to regulate anything vaguely associated with "finance." But, not knowing what went wrong really, it's approach is just to deputize appointed officials great power to write rules, or, more basically, direct affairs in real time.

Regulation is not "more" or "less" to be poured about. It is "smarter" or "dumber," solving clearly understood market failures with transparent rules, or simply sending busybodies around to muck things up.

We need "smarter." Soon.

Manna from Heaven: the Harvard Stimulus Debate

2012-03-04T11:32:00.001-06:00

Last week there was a fiscal stimulus debate between titans John Taylor and Larry Summers, at Harvard. Taylor wrote his opening remarks on his blog, which I recommend without further comment. Summers was quoted in the Harvard Crimson:

Summers also said that in studies comparing states that received varying amounts of stimulus money, those that received more money experienced higher levels of job growth.

This makes no sense as an argument for overall fiscal stimulus.

The fact is certainly possible. A good example of such studies is by Emi Nakamura and John Steinsson, summarized in their VoxEu blog post. Output rises in states that get more military spending:

...when aggregate military spending in the US rises by 1% of GDP, military spending in California on average rises by about 3% of California GDP, while military spending in Illinois rises by only about 0.5% of Illinois GDP. ...we can use regional variation associated with these buildups to estimate the effect of a relative increase in spending on relative output. Our conclusion is that when relative spending in a state increases by 1% of GDP, relative state GDP rises by 1.5%.

But they're upfront about the limits of this result:

Are multipliers of 1.5 too large to be true? ... some care is required in interpreting these empirical results. ... in our setting, the region getting the spending is not paying for it. (My emphasis)

And that's the problem.

Sure. Suppose the government pays contractors to build a military base, or to dig a ditch from Fresno to Bakersfield (high speed rail.) Is anyone surprised that GDP goes up in those areas? The contract itself is a government purchase, and adds to GDP, whether or not the project is of any use at all. When a donut shop relocates from LA, and people spend their salaries on donuts, that counts for more multiplier.

But where did the money come from? Showing that the government can move output around does not show that it can increase output overall. To build the base or rail line, the government had to tax or borrow the money. Cross-sectional studies do not measure the loss of demand in (say) Chicago from the money that got spent in Bakersfield. Actually, the studies can count the loss for stimulus: Every dollar that Chicago's GDP goes down from the extra taxes or borrowing means that the relative output in Bakersfield goes up.

Amazingly, our government has seemed unable to accomplish much of this manna-from-heaven local stimulus in the recent recession. (Steinsson and Nakamura's study was on military expenditure in general, the potential for such "stimulus," not how much of it actually happened in this recession.) John Taylor shows that the actual stimulus didn't even get spent, and when it did, didn't create many jobs. The Wall Street Journal had a nice article a few weeks ago, showing in detail how a $10 billion in stimulus money for wind farms produced few jobs. Even taking administration numbers at face value, we spent hundreds of thousands of dollars for each $50,000/year job "saved."

Larry may be citing studies of the recent recession that disagree. But I think it is a mistake to get too deep in this argument: As a matter of economics, the government should be able to move output around, making one area worse off and another better off. The delicious irony that it was unable to do much of that in this case shouldn't blind us to the fallacy of composition:

Stimulus has to be paid for. In evaluating stimulus for the whole economy, you have to count the loss of demand from the paying-for-it side equally with the raise in demand or employment from the spending-it side.

(If you like to cite New-Keynesian models, beware they are "Ricardian" so you can't even rely on the magic of borrowed money -- you have to defend the idea that taxing Chicago to dig a ditch in Bakersfield raises output on both places by one and a half times the tax. Not impossible (Jon and Emi try), but not as easy as it seems either.)

Summers was also quoted:

“Use your common sense,” Summers said. “Do you really believe if we had done nothing in response to the crisis in 2008, it would have been a good idea?”

That's too easy. Medieval doctors said, "the patient is dying, we must do something" before each bleeding.

I know it's unfair to criticize quotations in a college newspaper, so take these as comments on the (very common) ideas rather than anything personal about Summers or exact about the views he presented at the debate. I presume Larry said something a lot deeper.

The debate will be repeated at Stanford, and I hope we get a transcript or a video of this important event. This could be the Scopes Trial or Huxley–Wilberforce debate for fiscal Stimulus.

A story from Davos, and how Grumpy got his name

2012-03-04T09:09:00.000-06:00

I was reading Nick Paumgarten's New Yorker article about Davos in the bathtub this morning, and ran into this gem:

The Belvedere [hotel], ... is the annual meeting’s hub after dark. Often, there are a half-dozen parties going on at once. To get into it,...you must pass through airport-like security ... The line, on this night, was long enough that a Nobel laureate in economics, who, moments earlier at the Hotel National, had been holding forth on unfairness, deemed it worth cutting.

It would be easy enough to figure out who it was, but I like the story better as it is, a reflection on the Davos attitude, not a snarky comment on one individual. (If you know, please don't run it by outing him in the comments.)

A while back, on a lovely spring night, I was walking home with my family after dinner out. We observed one of Hyde Park's Great Liberal Minds, walking his ill-trained dog. He watched his dog deliver a a large steaming poop, and walked off, leaving the poop behind.

I opined, "well, there goes the Great Liberal; I suppose he thinks there is a Federal Department of Picking up your Dog Poop."

The kids laughed and dubbed me "Grumpy Economist" on the spot.

Update: I removed a few comments. I really do not want this to be personal.

Benn Steil and I debate house prices

2012-03-01T11:38:00.000-06:00

Last week Benn Steil wrote a very interesting oped on housing. (Originally at Financial News) He unearthed the amazingly large number of young people who bought houses in the boom, and then lost a lot when house prices fell. One quote:

What effect did the housing bust have on them? Household balance sheets among the Facebook generation were the hardest hit: between 2007 and 2009, half of those under the age of 35 lost over 25% of their wealth. A quarter of those under 35 lost over 86% of their wealth. Not surprisingly, they have been badly hit by the foreclosure tsunami; the median head of household in foreclosure being eight years younger than the median not in foreclosure. Younger households typically started off with less wealth than older ones and, following the bust, ended up with much less.

This bodes badly for their future, and the country’s

I wrote back, and the following exchange might be useful for blog readers here. We don’t come to hard and fast answers, but I think we clarified a lot of channels that do and don't work.

John:
Your oped was very interesting, but I have to disagree with a basic point. Lower house prices are great news for the majority of young households.
They either don’t own a house or are looking to trade up. Cheap stocks are also great news for them. Even those that lost money in one house will still want to live in houses for a long time, so they can buy a new house for the same low price that they sell their old houses for. Lower prices are only bad news for old people who want to downsize.

Benn:
For those that did buy – a lot – the data I cite say they’re in bad shape. For those that didn’t, you surely have a point, with the major caveat that credit standards are much, much tighter now (I’ve been through a mortgage and a refinancing over the past 2 years, and they were hell). You yourself have commented several times on the great rates that no one seems to have access to.

John:
The ones who bought surely are in bad shape, at least on paper. A young person who bought stocks on margin leveraged 90% in 2006 would also have lost a lot of money! But together with a collapse in wealth, there also has been a big decline in the cost of living – houses are cheaper. They don’t need as much wealth as before.

View it another way. They still have the house. If you bought a house in 2006, and you’re still employed, by and large your wages haven’t shrunk. You can have exactly the standard of living you had planned for in 2006, and it doesn’t matter a whit that the resale value of your house has declined. Really, look at it: same wage, same mortgage payment, same prices for stuff. So what if the house price went down? And even if you want to move - - again, you buy a new house for the same low price you sell your old hose. You can keep the planned standard of living.

OK the ones who are not employed have trouble. Or the ones whose wages are cut. But really, employment is the source of their trouble, not that the value of their house has gone down.

Benn:
If your net wealth, including home value, was $100,000 in 2006 and $10,000 today, you could still “have exactly the standard of living you had planned for in 2006”?

John:
If you can afford to buy the same basket of goods, you have the same standard of living.

Basically, it’s deflation. The deflation is not yet recorded in statistics because they use the rental equivalent measure of housing costs. If your net worth goes from $100,000 to $10,000 but there is a 90% deflation you are exactly as before.

As an extreme, suppose technical improvement makes housing free – we figure out how to grow houses from chia pets in a week. The price of existing houses goes to zero. There are winners and losers here too. But obviously as a society we are much better off.

Benn:
If I lose 90% on a stock am I no worse off because the broader index is also down 90%?

John:
You don’t live in stocks…

So, yes. If you lose 90% on a stock, but the stream of dividends is completely unchanged, then yes, you’re just as well off as before. If before you were planning to live off that stream of dividends, you can still do so. If before you were going to exchange the stock for a different one that gave a similar stream of dividends, you can still do so.

The key difference: Stocks typically fall when there is a big bad shift to the expected stream of dividends. When your house price falls, there is absolutely no effect whatsoever on its value to you as living space.

As with houses, you’re worse off if you were just about to switch from stocks to bonds. And you’re better off if you were young and about to invest in stocks, as now you get to buy the same dividends much cheaper.

(In retrospect I’m being a bit too strong, as usual. The fall in house prices comes with a lot of foreclosures and neighborhoods that are no longer great places to live. A lot of the houses are now in the “wrong places,” so genuinely less valuable. But for the argument here, that’s really about foreclosures costs, and the rise and fall of neighborhoods, i.e. collateral damage from house prices, not the direct effect of house price falls per se. Also, if you don't have the cash to pay off a mortgage and take the loss, moving is tough.)

Benn:
Is the ability to borrow against my appreciated home worth nothing, then?

John:
Now I have to give in a bit. Yes, this is a good point, and I ignored your credit point above.

Remember though that borrowing has to be paid back. So you bought a $100,000 house in 2005 with $10,000 down, and $1,000 per month mortgage. It goes up to $200,000. Great! Now you can refinance and take an extra $90,000 out of the house and go on that round the world cruise you had been hoping for. (Or start a business, or whatever.)

Whoops. Except now you have to pay the loan back. You have to pay $2,000 per month on your bigger mortgage. As long as you want to live in the house – or another one of the same size – you didn’t get any more wealth. “Removing a borrowing constraint” is different from “having more wealth.”

So you are better off, but only if you knew you were going to get a big raise, so that you wanted to borrow a lot of money but the bank wouldn’t let you. That might be true for a lot of people. On the other hand, we are perhaps becoming skeptical that it is such a great idea for young people to pile on a huge amount of debt, so perhaps not such a social tragedy that they can’t do it as easily any more.

But don’t confuse the size of a possible borrowing / collateral constraint with “wealth.”

That’s part of the transfer question. Those who rented did worse when house prices went up, and do better when house prices go down. There’s no question that It’s better to be a renter if you know prices are going down and vice versa. Just as it’s better to be out of the stock market when prices are going down.

Benn:
My point is precisely that the young, as a group, are worse off (irrespective of what they thought they knew about where prices were headed). I think there’s more than a fair debate to be had about the macroeconomic effects of this going forward. But surely what I’ve found on the demographics must be relevant to the question – so at least worth raising. No? . . .

John:
Yes indeed! I think we’ve talked about all sorts of interesting channels by which some groups benefitted, some were made worse off, and we all were made worse off by the end of the housing boom. Less collateral (for better or worse), houses built in the wrong places, half-finished houses, foreclosure externalities, the difficulty of young people starting carrers and so on.

But let’s also steer clear of the things that aren’t true, like the idea that just because the resale value of your house declines, you are automatically a lot poorer, especially if you are young and going to live in the house for a long time.

(A special thanks to Benn for graciously agreeing to let me post our exchange.)

Weird stuff in high frequency markets

2012-02-28T11:53:00.001-06:00

On the left is a graph from a really neat paper, "Low-Latency Trading" by Joel Hasbrouck and Gideon Saar (2011). You're looking at the flow of "messages"--limit orders placed or canceled--on the NASDAQ. The x axis is time, modulo 10 seconds. So, you're looking at the typical flow of messages over any 10 second time interval.

As you can see, there is a big crush of messages on the top of the second, which rapidly tails off in the milliseconds following the even second. There is a second surge between 500 and 600 milliseconds.

Evidently, lots of computer programs reach out and look at the markets once per second, or once per half second. The programs clocks are tightly synchronized to the exchange's clock, so if you program a computer "go look once per second," it's likely to go look exactly on the second (or half second). The result is a flurry of activity on the even second.

It's likely the even-second traders are what Joel and Gideon call "Agency traders." They're trying to buy or sell a given quantity, but spread it out to avoid price impact. Their on-the-second activity spawns a flurry of responses from the high frequency traders, whose computers monitor markets constantly.

There's a natural question: Is this an accident, or is there intentional "on the second" bunching? You can see that a programmer who didn't think about it would check once per second, not realizing that means exactly on the top of the second. But sometimes there is more liquidity when we all agree to meet at the same time. Volume has always been higher at the open and close. Joel and Gideon show the pattern lasted from 2007 to 2008, so was not an obvious short-term programming bug. (Do notice the vertical scale however. The range is from 9 to 13, not 0 to 13.) I'd be curious to know if it's still going on.

Here's another one, found by one of my students on nanex.net here. (Teaching has many benefits when the students know more about markets than you do!).

You're looking at bids, asks, and (white dot) trades in the natural gas futures markets. From nanex:

On June 8, 2011, starting at 19:39 Eastern Time, trade prices began oscillatingalmost harmonically along with the depth of book. However, prices rose as bidwere executed, and prices declined when offers were executed .....price oscillates from low to high whentrades are executing against the highest bid price level. After reaching apeak, prices then move down as trades execute against the highest ask pricelevel. This is completely opposite of normal market behavior....It's almost as if someone is executinga new algorithm that has it's buying/selling signals crossed. Most disturbingto us is the high volume violent sell off that affects not only the natural gasmarket, but all the other trading instruments related to it.

I'm generally give efficient markets the benefit of doutbt, but it's hard not to suspect that some programming bugs are working against each other here. It's hard enough to debug a program to work alone, but when 17 programs work against each other all sorts of interesting weirdness can spill out. I am reminded of work in game theory in which computer programs fight out the prisoner's dilemma and all sorts of weird stuff erupts. If so, this will settle down, but it may take a while.

The Economist reports an interesting related story.

ON FEBRUARY 3RD 2010, at 1.26.28 pm, an automated trading system operated by a high-frequency trader (HFT) called Infinium Capital Management malfunctioned. Over the next three seconds it entered 6,767 individual orders to buy light sweet crude oil futures... Enough of those orders were filled to send the market jolting upwards.

A NYMEX business-conduct panel investigated what happened that day.... Infinium had finished writing the algorithm only the day before it introduced it to the market, and had tested it for only a couple of hours in a simulated trading environment to see how it would perform. .... When the algorithm started its frenetic buying spree, the measures designed to shut it down automatically did not work. One was supposed to turn the system off if a maximum order size was breached, but because the machine was placing lots of small orders rather than a single big one the shut-down was not triggered. The other measure was meant to prevent Infinium from selling or buying more than a certain number of contracts, but because of an error in the way the rogue algorithm had been written, this, too, failed to spot a problem. ..

High frequency trading presents a lot of interesting puzzles. The Booth faculty lunchroom has hosted some interesting discussions: "what possible social use is it to have price discovery in a microsecond instead of a millisecond?" "I don't know, but there's a theorem that says if it's profitable it's socially beneficial." "Not if there are externalities" "Ok, where's the externality?" At which point we all agree we don't know what the heck is going on.

There is also the more prosaic question whether high frequency traders "provide liquidity" and thus are in some sense beneficial to markets, or if they are somehow making markets worse. A question for another day (there is some interesting new research).

There are lots of reports of how profitable it is. But high frequency trading is a zero sum game. Anything you do in milliseconds can only talk to another computer. By definition, they can't all be making money off each other.

Hope for Europe

2012-02-22T22:36:00.001-06:00

A provocative Wall Street Journal OpEd by Donald Luskin and Lorcan Kelly gives me hope for Europe.

No, I'm not talking about Greece, and the latest bailout deal. That's more of the usual charade. But in the end Greece is small. Europe can bail Greece out if they feel like it; or let it default.Or let it rot, which seems where they are headed.

Italy and Spain are where the real issue lies. Italy and Spain are too big to bail.

Growth is the only hope for paying back large government debts. "Growth" to an economist means long-run growth, growth that lasts decades. Even the most hard-bitten Keynesian, if honest, has to admit that "stimulus" does not produce long-run "growth." Growth comes from more people or more productivity. Period. Italy and Spain can only grow if they free up their markets, clean up their tax systems, put themselves quite a few notches higher on the list of good places to do business.

Growth is also essential for solving the more immediate debt problems. Italy and Spain need to roll over debts. Markets can be quick to do that, and even lend more, if they see countries have good long-run growth prospects. Markets will stay away as long as they do not see a coherent plan for long-term growth. ("Growth" is distinct from "austerity." "Austerity" means high and distorting taxes, spending cuts but no liberalization of the economy. This quickly runs the economy into a death spiral as people and money leave.)

I had long thought that like the Greeks -- or, increasingly, like the Americans -- Italy, Spain and the rest of Europe (Belgium? France?) simply did not have the will to free their economies. If so, Europe seemed to me destined for a huge bout of inflation. The ECB is basically buying up the debt (via the banks); if the debt can't be bailed out, defaulted on, or repaid, it must end up with inflation.

But, as Luskin and Kelly point out, I may have for once been too Grumpy. Mario Monti, Italy's prime minister, is on a rampage of liberalization. They quote him, growth "will have to come from structural reforms or supply-side measures." Spain's prime minister Mariano Rajoy is headed in the same direction. Monti and Rajoy recognize that companies will only hire people if they can later fire them; that barriers to entry for all the professions ("from pharmacy and baking to taxi-driving") just drag down the economy, that state industries don't provide "jobs," but instead suck the lifeblood out of growth.

Will they get there? Will they reestablish growth soon enough to get the bond markets to roll over debt, or pay back the ECB before it needs to unwind its purchases to avoid inflation? It will be dicey. There is a lot of entrenched opposition to liberalization -- which is why obviously good ideas have such a hard time being implemented for decades. But, as my mayor once said, a crisis is a terrible thing to waste. Maybe Monti and Rajoy can achieve the needed "grand bargains."

What is remarkable -- what gives me hope -- is that they are even talking about "supply side" growth measures and liberalization at all!

The Conventional Wisdom makes no connection between stifling labor market regulations and a debt crisis. The debt crisis is about "confidence" and "contagion," to be met with bailout funds, "firewalls," financial engineering, and ECB debt schemes.

For example, in her most recent speech, IMF Director Christiane Lagarde recommends that "stronger growth" come first of all from "additional and timely monetary easing." Then, "raising [bank] capital levels" (Note the usual passive policy voice -- who does this raising and how? Translation: taxpayers give money to banks.) Then, "maintaining orderly funding conditions" whatever that means. (Watch your wallet.)

She warns that " On fiscal policy, resorting to.. budgetary cuts will only add to recessionary pressures...those with fiscal space should support the common effort by reconsidering the pace of adjustment planned for this year." Translation: Economies with stratospheric debt/GDP ratios need just a little more fiscal stimulus. As St. Augustine lamented, Lord give me frugality, but not quite yet.

The bond market? She wants a "larger firewall.... Adding substantial real resources..folding the EFSF into the ESM, increasing the size of the ESM,.." Then, "Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets would also be essential." Translation: ECB to buy debt with printed Euros.

Eventually, yes, "some countries still have much to do to boost their competitiveness and growth potential." Some? What, most of Europe is right on its "growth potential? And finally, at the very end, "..structural reforms are critical, however medium or long-term their impact might be. ... fiscal sustainability depends, ultimately, on generating long-term growth." Four or five years down the line, maybe, meekly approach Italy's unions and government-run industries with a request for "structural reforms." Sure, that's going to work.

I don't mean to pick on Lagarde. Her speech is just a good example of global bien-pensant policy Conventional Wisdom. I'm sure everyone murmurs this sort of thing at Davos. Grumpy's favorite columnist, Paul Krugman is, believe it or not, arguing for more spending and stimulus across Europe. I'm not exactly clear how he wants Italy, Spain, Portugal or Greece to borrow more money to spend it. Budget constraints are never the forte of Keynesian economics. He seems to saying that multipliers are so large that spending is self-financing: "Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to G.D.P." It's either that or the Easter bunny: I don't see bond markets ponying up more stimulus. But "growth," tackling absurd regulations, unions, labor market rigidity denying employment to a generation of Italians and Spaniards... that' s not even on his agenda.

In this noxious intellectual environment, it is remarkable and praiseworthy that Monti and Rajoy are putting "supply side growth" on the front burner at all; that they make a connection between a debt crisis and sclerotic microeconomics. This is a Reagan / Thatcher moment, when courageous politicians may seize the moment of crisis to jump to the long run; let their economies grow and pay off a mountain of debt, ignoring the Conventional Wisdom. It could happen. Or not, but at least there finally is hope.

In bocca al lupo ("good luck" in Italian -- and, literally, "into the mouth of the wolf," an unusually apt expression) Signor Monti!

Taylor on Lehman and TARP

2012-02-22T16:45:00.000-06:00

John Taylor took the trouble to respond to Paul Krugman's latest outrage on the sources of the financial crisis. Taylor's post -- along with the deeper analysis he points to -- is well worth reading.

Krugman's calumnies are so nonsensical I generally do not find it worth responding.

The idea that I now like stimulus is simply preposterous if you bother to read what I write about it. (Here, here and here.) The idea that I or John Taylor don't think there was a run is even more preposterous. (One of many examples here, p. 7: "Why was there such a large fall in output? For once in macroeconomics we actually have a good idea what the shock was—there was a ‘‘run’’ in the shadow banking system.")

To top it off, Krugman writes "Anyone else have the impression that something happened in the second half of September 2008?" I mean really, accusing Taylor and myself of thinking that nothing happened in September 2008? Are Krugman's readers such simpletons that they fall for such unvarnished falsehoods?

Taylor did us a service by taking the time to straighten this one out.

Yes there was a run.

Taylor's detailed work shows what many of us sensed: That the run was not triggered by Lehman's bankruptcy. Instead a good part of the run can be laid at the feet of Treasury Secretary Paulson, who showed up on national TV asking for 700 billion dollars, with three sheets of paper in front of him, no clear explanation of what he wanted to do with the money, and with a hastily-imposed short-sale ban on bank stocks. How to Cause A Run 101.

More importantly, Taylor's work also puts to rest Krugman's idea (last sentence) that Lehman caused or threatened a chain of bankruptcies. Ed Lazear puts it nicely: it wasn't dominoes, it was popcorn.

That's what a run is. When a piece of news comes out that banks may be in trouble, people pull their money out of all the banks at the same time. Krugman is being simply incoherent in first calling it a run and then a threatened chain of bankruptcies only saved by further bailouts.

In fact, the run is central to my view of the crisis and its lessons. I doubt Krugman has thought through the implications carefully, along with the distinction between dominoes and popcorn, as they run directly counter to his worldview.

Runs don't have a single cause, they have a straw that broke the camel's back. Ask yourself, would simply bailing out Lehman have avoided this whole mess? Obviously not. People saw Lehman go under -- and Paulson's speech, plus short-sale ban, plus everything else going on at the time -- and asked themselves, "gee, my bank was investing in the same things Lehman was. I wonder how they're doing? I'd better pull my money out just to be safe." ("People" here means institutional investors in the shadow-banking system, i.e. prime-brokerage customers, repo investors, derivatives counterparties, asset-backed security investors.)

In the circumstances of Fall 2008, suppose that the government had announced a big Lehman bailout, especially along with Paulson's speech. Well, you come to just about the same worries about your own bank, as if Lehman had not been rescued, don't you? If they had to rescue Lehman, they must have been in real trouble. I wonder if my bank is in similar trouble?

Actually it would have been worse. such a bailout would have also come with a howl of protest, and it was clear that the bailouts would have to end somewhere, and the next one would be bigger. AIG? Citigroup? Hmm, let's take our money out extra special fast as a big blowup is coming this way.

The insight that it was a run is central to my view of how to fix things. If it was a run, echoing, as Krugman says, Friedman and Schwartz's view of the Great Depression, then some of Friedman and Schwartz's conclusions are surely warranted! No, this was not some mysterious failure of capitalism and we need to have the Fed run everything under Dodd-Frank. No, this does not require that we save every big institution and protect them from competition and failure forever. This was one run very like the many runs and panics we've seen throughout history.

Our run was in the shadow-banking system. I recommend Darrel Duffie's "Failure mechanics of dealer banks," the article and the book Once you read these, you naturally see simple ways in which we can fix bankruptcy law and run-prone assets in place of Dodd-Frank. How, exactly? That's a subject for another post -- actually a long series -- coming up.

Yes it was a run. And that fact leads directly to some very un-Krugmanlike conclusions.

(If you want to read what I actually have written so far about this issue it's all here. I'm teaching a class this week on financial crisis -- we're going to spend a lot of time on Duffie and Gary Gorton's analysis of the run in repo markets.)

Fed Independence 2025

2012-02-19T10:55:00.001-06:00

Headline: The Fed just forced mortgage servicers that got caught submitting "documents that were not properly notarized," among other sins, to cough up money towards principal reduction, for people unaffected by the notarization scandal, as well as to fund "nonprofit housing counseling organizations" and other policy objectives.

Deeper question: What will the Fed look like in 2025? How long can it stay independent as it takes on more and more power, and uses that power for these kinds of political policy actions?

Act 1: Three recent news items add up to a scary picture.

Item 1: Led by the White House, the state Attorneys General announced their "settlement" with banks.

Here's what happened. Suzie, Bob, and Joe each bought $300,000 houses, that are now worth $200,000. Suzie stopped paying, and was foreclosed. Bob borrowed $280,000, so he's "underwater," but he likes his house, doesn't want to ruin his credit, and is still paying his mortgage. Joe only borrowed $200,000 and is also still paying.

The banks got caught robo-signing Suzie's paper work. The Administration and Attorneys General (with the laudable exception of Oklahoma) used the threat of prosecution to get the banks to lower Bob's principal by $20,000. Suzie might get a small check. Joe gets nothing.

There is a story for doing this. Bob might decide to stop paying his mortgage, forcing the bank to foreclose. The foreclosure might lower the value of his neighbor's property.

There are also costs. This money comes from somewhere -- the mortgage investors, the bank equity holders, or eventually the taxpayers. Maybe they had better things to do with $20,000. Maybe banks and investors, seeing their contracts torn up ex-post by the government, are going to be a whole lot more careful about who they lend to in the future. We live in a time of 3.5% mortgages that nobody can seem to get. To say nothing of the blatant unfairness, and moral hazard, of giving Bob this little present for taking out a huge loan, or the larger moral hazard of using the threat of prosecution for procedural errors to force anyone to cough up money towards unrelated policy goals.

As you can guess, I think it's a rotten idea. The Fed's own White Paper on Housing puts the ineffectiveness of the policy and its costs better than I can, citing the relevant research. Look at the top of p. 21.

But that's not important here. Even if you think it was a great idea, you have to admit it is a controversial policy, one on which there is likely a strong partisan divide. You also have to admit that the Administration threatened the banks with prosecutions to force them to finance a policy goal having nothing to do with the actual legal case.

Ok, that's the kind of tough hardball that the executive branch plays. Which is why, in our society, they have to face the voters.

Item 2: The Federal Reserve thinks foreclosures and underwater mortgages are a big problem too, and has been cheering the Administration's various mortgage-modification programs. See Governor Elizabeth Duke's Speech on September 1, or Ben Bernanke speech on February 10, titled "Rebalancing the Housing Market" -- a new job for the Fed -- or the Fed's extensive White Paper on Housing. (Actually, reading this stuff, the Fed seems much more keen on "government-facilitated rent-to-own programs," but that's an intervention for another day.)

Item 3: In case you missed it, the Federal Reserve is taking on regulation of financial institutions at a very detailed level. I reviewed its massive plan to regulate large banks in an earlier oped and blog post The Fed just announced its plans to actually go forward and "designate" non-banks as "systemically important" and subject to its mercies as well. Together with the new "Consumer Financial Protection" bureau, located in the Fed, the Fed can and will tell large banks what to do at an amazingly detailed level.

Let's put two and two together. How long will it be until the Fed starts acting like the Administration. "Nice bank you have there. Wouldn't want anything to happen to it. Those consumer financial protection nerds can be a real pain in the butt, can't they? To say nothing of those wonks down in the systemic risk department. Say, we notice you're still sitting on a lot of reserves, and nobody's lending to support the housing market in Detroit. Sure would be nice if you pitched in and helped a bit. And why aren't you writing down mortgages instead of foreclosing on all those houses?"

I don't mean to ascribe any bad motives here. The people I know at the Fed are all well-meaning and really smart. The problem is the power. If you really believe that "the market is not functioning as it should." (Elizabeth Duke, Sept 1), i.e. that the housing markets are impeding recovery, and that banks could do a lot about it; if your institutional mandate includes micromanaging the state of the economy by watching individual markets, and detailed regulation of bank's activities, the outcome is inevitable: You will soon be using your regulatory power to force the banks to accomplish policy goals.

Act 2: It's already happening

As I was writing this, I thought I was writing one of my usual doom-and-gloom worries about the far-off future. Browsing the Fed's website, it turns out it's already happening. For the Fed is a party to the Administration's deal, and is using its banking supervision powers to force mortgage reductions.

The Fed announced its actions in a February 9 press release

The Federal Reserve Board ...has reached an agreement in principle with five banking organizations regarding the issuance of monetary sanctions against the organizations totaling $766.5 million. The monetary sanctions would be assessed for unsafe and unsound processes and practices in residential mortgage loans servicing and foreclosure processing.

... the Board is acting in conjunction with a comprehensive settlement agreed in principle between the five banking organizations, the state Attorneys General, and the Department of Justice on February 9, 2012 ("Settlement Agreement"). The Settlement Agreement requires these organizations to provide $25 billion in payments and other designated types of monetary assistance and remediation to residential mortgage borrowers.

It's right there in print:

1) The Fed is using its banking supervision powers, to call the robosigning scandals "unsafe and unsound" banking practices.

2) The Fed is acting in conjunction with the Administration -- so much for independence and standing outside of politics.

3) The Fed is forcing the banks to write down mortgages and provide other "assistance," policy goals unrelated to the actual "unsound processes and practices."

The details, in the followup Feburary 13 press release are even more astonishing. Reading from the Ally Financial settlement,

WHEREAS, the Mortgage Servicing Companies [Ally Financial Subsidiaries], ... allegedly:

(a) Filed or caused to be filed...numerous affidavits.. making various assertions, such as the ownership of the mortgage note and mortgage, the amount of principal and interest due, and the fees and expenses chargeable to the borrower, in which the affiant represented that the assertions in the affidavit were made based on personal knowledge or based on a review by the affiant of the relevant books and records, when, in many cases, they were not based on such knowledge or review;

(b) Filed or caused to be filed in courts... numerous affidavits and other mortgage-related documents that were not properly notarized,..

(c) Litigated foreclosure and bankruptcy proceedings... without always confirming that documentation of ownership was in order at the appropriate time, including confirming that the promissory note and mortgage document were properly endorsed or assigned and, if necessary, in the possession of the appropriate party...

Heavens, what a scandal...Documents not properly notarized! Notice it does not even "allege" that anyone was actually kicked out of a house who was paying their mortgage.

WHEREAS, as part of the Settlement Agreement the Ally Parties agreed to provide consumer relief, which may include mortgage principal reductions or refinancing, and other assistance to certain residential mortgage borrowers (the “Borrower Assistance”)

NOW, THEREFORE, ..and solely for the purpose of settling this matter without a formal proceeding being filed and without the necessity for protracted or extended hearings or testimony, it is hereby ORDERED by the Board of Governors,... that:

1. Ally Financial, ResCap, and the Mortgage Servicing Companies are hereby jointly and severally assessed a CMP [civil monetary penalty] in the amount of $207,000,000...

2. ...the Board of Governors shall remit up to $207,000,000 of the CMP by an amount equivalent to the aggregate dollar value of the Borrower Assistance provided....

3. .. the Board of Governors shall also remit up to $207,000,000 of the CMP... by an amount equivalent to the aggregate amount funds expended by Ally Financial, ResCap, and the Mortgage Servicing Companies on funding for nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development, to provide counseling to borrowers who are at risk of or are in default or foreclosure, or to provide assistance to borrowers in connection with the independent foreclosure reviews required by the Consent Order...

Again, right there in print:

1) Ally is to provide "relief" to borrowers, not victims of the lack of notarization.

2) They're doing it to avoid the threat of huge legal bills.

3) Legally, the Fed can't tell Ally to write people checks. So, the Fed is going to levy a $207 million penalty because Ally's lack of notarization is an "unsafe and unsound" practice. Then the Fed will "reduce the penalty" by exactly the amount that Ally spends on "borrower assistance."

4) It's not just writedowns, but all the hilarious stuff in the last paragraph -- "funding for nonprofit housing counseling organizations!" Stuff that the Administration wouldn't dare put in a budget it sent to Congress.

It's a bit puzzling that the Fed signed on to this agreement, actually. As above, the White Paper on Housing and Fed official's speeches are pretty negative on mortgage writedowns. One sniffs a lot of pressure coming form the White House.

Which is the danger, for the Fed, of getting involved in these policies at all: Who knows what great ideas the Santorum Administration will have for the Fed to "support manufacturing," or the Romney Administration will have for its idiotic "day 1" currency war with China? Now we know what the Fed is, it is only a matter of the price. It would be have been far better for the Fed to say, "as the price of our independence, we're not allowed to do things like this."

Act 3: Independence

The Fed is set up to be politically independent, and central bank independence is a cherished principle of monetary economists.

Academics typically think the Fed's main job is to control short-term interest rates: too high and we get unemployment, too low and we get inflation. Fed "independence" helps it to make this decision without too much political interference. Such interference might skew the decision to temporary stimulus at the expense of long-term inflation.

Before the financial crisis, thinking around the world was moving towards the idea that the central bank's job is really just to control inflation. Efforts to micromanage the economy were largely seen as illusory. This view was embodied in the ECB's mandate and many "inflation-targeting" regimes. The whole banking supervision part of the Fed was a separate backwater, unrelated to the Fed's macroeconomic policy roles.

That all seems so quaint now. The Fed is now the Gargantuan Financial Regulator, as well as Controller and Stimulator of the Macroeconomy. Its macroeconomic role is increasingly the Supporter of Particular Markets and the Allocator of Credit. It's also getting in to the business of running whole markets, i.e. the details of how mortgages are written and serviced. And it's loudly cheering for particular Administration policies such as mortgage modifications. Monetary policy is way down the list.

The price of independence is limited power. Central banks that only try to control inflation, and only using one tool, such as purchases and sales of Treasury debt, can be walled off from the political process. As a country, we can decide that the price level will not be used for political purposes and assign its maintenance to technocrats.

The Fed was assigned great power after the financial crisis. It's more competent than most of the other agencies, and as a result of its historic independence can act with great power. But this situation cannot last. The Federal Reserve cannot command that one group of voters cough up $20,000 checks to another group of voters, and not expect those voters to want a say in the matter. Locating financial regulation in the Fed may turn out to have been a terrible idea.

What to do? Good question. My preferred answer would be to save the independence, competence, and a-political nature of the Federal Reserve. That means breaking up its functions. Focus monetary policy on the price level, and stop pretending to micromanage activity. In any case, separate monetary policy from financial regulation -- break the institution up so that financial regulation tools cannot be used to promote macroeconomic policy goals, except by direct political intervention, by politically accountable officials.

The alternative is to bring the whole of the Federal Reserve's activities under much more direct control and accountability to elected officials. I have no more faith in the wisdom of elected officials than the next person, so I foresee a politicized Fed will be disastrous. But our society is not built on faith in the wisdom of an unaccountable aristocracy with huge power and no supervision. That will be even more disastrous. That's where the Fed is going, and it cannot last.

Where your money goes

2012-02-15T07:51:00.000-06:00

Two nice graphs from the New York Times

Comment: Now, could we please stop talking about how we need more taxes to pay for roads and bridges or to help the poor? The main function of our government is to write checks to middle-class and wealthy voters. And that's the reason its finances are in the toilet.

This means Elizabeth Warren, for example, who said a factory owner needs to pay more taxes because "you moved your goods to market on the roads the rest of us paid for; you hired workers the rest of us paid to educate; you were safe in your factory because of police forces and fire forces that the rest of us paid for." Answer: you paid for that long ago. That's not where the money is going.

This means Robert Frank, whose NYT "Economics view" argued for "higher taxes needed for improved infrastructure" and claimed "when the anti-tax wealthy make campaign contributions, they are buying only the deeper potholes and dirtier air that inevitably result when tax revenue is low." No, that's not where the money is going either.

(Frank's article is hilarious in another way. Higher taxes are fine, he says, because more money won't make you feel better when everyone around you is wealthier too. Too much low-hanging fruit there, just go read it and have a laugh. Or shake your head in amazement. No, he's not joking.)

The point, today, is not whether these checks are a good idea. The point is just this: let's argue honestly about the actual issue. Ms Warren, Mr. Frank, and company: argue wholeheartedly that you want higher taxes to keep the checks coming and write more of them. Opponents: argue the opposite. But leave the roads, bridges, the poor and the environment out of the debate over higher taxes.

Nor am I being heartless. I think we should be doing more to help the genuinely poor, especially the mentally ill that wander the streets of Chicago. I like roads and bridges as much as the next guy (though I must note that building more highways is a very recent liberal priority!) But these priorties are just irrelevant to the current taxation and spending debate.

PS. Of course the Times article was trying to make the opposite point -- that all these middle-class recipients of government largesse were being silly for not supporting politicians who promised to give them more money. The idea that these hearty middle class people were actually smarter than Times writers, and saw that the system would soon break down, did not occur to the Times.

Wallison on financial regulation

2012-02-13T10:17:00.002-06:00

Peter Wallison has an important Op-Ed in the Wall Street Journal last week (AEI link) titled "Dodd-Frank and the Myth of Interconnectedness"

The chain of bankruptcies is one of the central myths of the financial crisis. A owes money to B, B owes money to C, C owes money to D. If A fails, it wil result in a chain of bankruptcies where B, C, and D fail too.

As Peter points out, it simply did not happen. We had a run, not a chain of bankruptcies.
A (L actually!) failed, investors noticed that B, C and D were invested in many of the same things, and stopped lending to B, C and D; B, C and D also stopped lending to each other. Everyone tried to buy Treasuries. Since the banks were funding themselves by overnight debt, they were supremely exposed to such a run.

Getting it wrong matters. To produce a sensible regulation of the financial system, it helps to have a vaguely coherent idea of what happened -- and what did not happen. The Dodd-Frank/Fed approach seems to be "we don't know what happened, really, so we'll just regulate everything that moves."

On the chain of bankruptcies theory, and as directed by Dodd-Frank, the Fed is getting ready to monitor and regulate all links between "systemically important" institutions, and implement regulatory limits on their cross-exposures. I reviewed this in an earlier WSJ oped, and pointed out how fairly hopeless the effort is.

The central idea of Dodd Frank, which the Fed is now endorsing and implementing, comes down to this: no "large," "systemically important," "interconnected," or whatever (nobody knows what these words mean) will be allowed to fail. The Fed will be looking over their shoulders the whole time.

That approach will necessarily mean protecting them from competition. How else do you make sure they're "strong," and will never get in trouble? And it's only a matter of time that "policy goals" get enmeshed with "regulation." See last week's agreement whereby banks agreed to lower principal amounts on one group of homeowners, as "settlement" against their paperwork problems with another completely unrelated group. The Fed is pushing hard for banks to "do more" for housing... you can see where this will go fast.

If, instead, we had a run, as I and Peter believe, that sends you thinking in a completely opposite direction. In my view, it means we need to get rid of the institutional focus -- protecting specific "systemically important" institutions -- and instead focus on the run-prone assets. Peter seems to lean more to the "common shock" problem. But either line of thought is a long way from what's going on in the dungeons of the Fed.

The Real Trouble With the Birth-Control Mandate

2012-02-08T21:01:00.001-06:00

(This is a Wall Street Journal Op-Ed. If you don't subscribe, there is a pdf on my webpage.)

When the administration affirmed last month that church-affiliated employers must buy health insurance that covers birth control, the outcry was instant. Critics complained that certain institutions should be exempt as a matter of religious freedom. Although the ruling was meant to be final, presidential advisers said this week that the administration might look for a compromise.

Critics are missing the larger point. Why should the Department of Health and Human Services (HHS) decree that any of us must pay for "insurance" that covers contraceptives?

I put "insurance" in quotes for a reason. Insurance is supposed to mean a contract, by which a company pays for large, unanticipated expenses in return for a premium: expenses like your house burning down, your car getting stolen or a big medical bill.

Insurance is a bad idea for small, regular and predictable expenses. There are good reasons that your car insurance company doesn't add $100 per year to your premium and then cover oil changes, and that your health insurance doesn't charge $50 more per year and cover toothpaste. You'd have to fill out mountains of paperwork, the oil-change and toothpaste markets would become much less competitive, and you'd end up spending more.

How did we get to this point? It all leads back to the elephant in the room: the tax deductibility of employer-provided group insurance.

If your employer pays you $100 less in salary and buys $100 of group insurance for you, you don't pay taxes on that amount. Hence, the more insurance costs and covers, the less in taxes you seem to pay. (Even that savings is an illusion: The government still needs money and raises overall tax rates to make up the difference.)

To add insult to injury, this tax deduction does not apply to portable, guaranteed-renewable individual insurance. You don't get the tax break if your employer gives you the $100 and you buy a policy—a policy that will stay with you if you get sick, leave employment or get divorced. The pre-existing conditions crisis is largely a creature of tax law. You don't lose your car insurance when you change jobs.

Why did HHS add this birth-control insurance mandate—along with "well-woman visits, breast-feeding support and domestic-violence screening," and "all without charging a co-payment, co-insurance or a deductible"—to its implementation of a provision of the new health-care reform law? "Because it promotes maternal and child health by allowing women to space their pregnancies," says the HHS advisory panel. Because these "historic new guidelines" will make sure "women have access to a full range of recommended preventive services," says the original HHS announcement. To "increase access to important preventive services," echoes White House Press Secretary Jay Carney.

Notice the doublespeak confusion of "access" and "cost." I have "access" to toothpaste because I have two bucks in my pocket and a competitive supplier. Anyone who can afford a cell phone can afford pills or condoms.

Poor women who can't afford birth control are a red herring in this debate. HHS isn't limiting this mandate to the poor. We all have to pay. The very poor typically don't have employer-provided health insurance in the first place.

"Allowing women to space their pregnancies"? Was there some sort of federal ban on birth control before this?

It's not about "access" and it's not about "insurance." It's because Americans, when paying even modest co-payments, choose to spend their money on other things. They prefer a new iPod to a "wellness visit" to the doctor. As the HHS unwittingly admits: "Often because of cost, Americans used preventive services at about half the recommended rate."

Remember, we're supposed to be worrying about skyrocketing health-care expenses. Doubling the number of wellness visits and free pills sounds great, but who's going to pay for it? There is a liberal dream that by mandating coverage the government can make something free.

Sorry. Every increase in coverage means an increase in premiums. If your employer is paying for your health insurance, he could be paying you more in salary instead. Or, he could be lowering prices and selling his product to you and all consumers more cheaply. Someone is paying. Not even HHS tries to claim that these "recommended preventive services" will lower overall costs.

Here's a good mandate: Let's mandate that every time a government official says that the government is going to "help" some category of voter, he or she has to say who they are going to hurt in the same sentence. Because it has to be someone.

But what about the fact, you may ask, that unwanted children are a burden on society as well as to their mothers? Perhaps there is a social interest in subsidizing birth control? Perhaps there is—but if so, this is an awful way to do it.

If pills are "free," under insurance, the incentive for drug companies to come up with cheaper versions vanishes. So does their incentive to develop safer, more convenient, male-centered or nonprescription birth control. And by making pills free but not condoms, the government may inadvertently be contributing to an increase in sexually transmitted diseases.

The taxes and spending we argue about are the tip of the iceberg. Salting mandated health insurance with birth control is exactly the same as a tax—on employers, on Catholics, on gay men and women, on couples trying to have children and on the elderly—to subsidize one form of birth control.

If the government wants to subsidize birth control, OK, pass an explicit tax, and sensibly subsidize all birth control. And face the voters on it. The tax rate and spending debates that occupy the media are a small part of the effective taxes and spending that the government achieves by these regulatory mandates.

There is also the issue of religious freedom. Our nation is divided on social issues. The natural compromise is simple: Birth control, abortion and other contentious practices are permitted. But those who object don't have to pay for them. The federal takeover of medicine prevents us from reaching these natural compromises and needlessly divides our society.

The critics fell for a trap. By focusing on an exemption for church-related institutions, critics effectively admit that it is right for the rest of us to be subjected to this sort of mandate. They accept the horribly misnamed Patient Protection and Affordable Care Act, and they resign themselves to chipping away at its edges. No, we should throw it out, and fix the terrible distortions in the health-insurance and health-care markets.

Sure, churches should be exempt. We should all be exempt.

(All health-insurance artilcles and opeds)

Taylor's graphs

2012-02-07T12:06:00.002-06:00

John Taylor wrote a very nice blog post, "Reassessing the recovery". He made two graphs, reproduced here. On the top you see the current recession and recovery. On the bottom you see the typical pattern, exemplified by the biggest previous postwar recession in 1982.

We usually bounce back to the trend line. Now, we're not.

The difference betwen "levels" and "growth rates" accounts for a lot of confusion in popular discussions. "Recessions" are pretty much defined as times in which GDP is declining -- negative growth rates, the level is going down. GDP stopped going down in early 2009.

Yet, as many commentators point out, if the recession is over, why does it feel so glum out there? Answer: because prosperity is measured in levels. Employment responsds to levels.

The big macroeconoimc question for our time is this: Just why are we stuck at a much lower level? What do we need to do to get back to the trend line? Or is that trend line illusory?

There are two stories -- and I use that word advisedly.

1) "Demand." We're about a trillion dollars below trend, so the government needs to borrow an additional $750 billion a year (I'm usuing the Keynesian 1.5 multiplier) and blow it on whatever is handy; Solyndras, high speed rail, windmills, any old rathole will do so long as it's "spent." (Sorry, I'm not doing a very good job of expounding this position. Not my job.) Or just let it be stolen, as thieves have high marginal propensities to consume. The problem is the intractable thriftiness of American consumers, so the government just needs to spend more, or borrow or tax money and give it to people who will.

Monetary policy is close to powerless now, but promising zero percent interest rates for a decade helps; those 3.5% mortgages that are strangling credit could be brought down to 3.4%.

2) "Supply." Companies are skittish about using incredibly low rates to build new houses or factories. Over-regulation, uncertainty, fear of political interference, labor-market mismatches are holding us back. (Steve Davis, Scott Barker and Nick Bloom have a nice paper that tries to quantify this story.) Boeing's efforts to start a factory in South Carolia writ large. As a little recent example, the collected attorneys general of several states have got the banks to cave and send foreclosed homeonwers big checks. The banks are certainly going to learn to be much more careful about who they lend to in the future, which has something to do with 3.5% mortgages that nobody seems to qualify for.  There are also stories about housing problems spilling over to the real economy, which I don't agree with, but are still basically "supply" stories.

The uniting features of "supply" stories is that, even if you think fiscal/monetary stimulus works in general, they won't work now.

In short, is our problem "micro" or "macro," "supply" or "demand," a mysteriously lingering business cycle, or the outbreak of a long-term growth slowdown? I lean to "supply," but the stories are not really quantified let alone easy to distinguish. Hence the repeated "micro vs. macro" thoughts on this blog.

This matters for all sorts of reasons. All of the projections that show our fiscal problems getting better in the near term before the entitlement bomb hits rely on our quickly closing the gap. If we don't close the gap, we never make progress on the deficit, and our future looks like Greece a lot sooner.

Monetary policy might help "gaps" but it can't fight "trends" or "supply." Jim Bullard, President of the St. Louis Fed, gave an interesting  speech  in Chicago yesterday pointing this out. Though I disagree with his analysis of why we might never get back to trend (housing prices as a "wealth shock"), his basic point is deeper: If the "trend" is illusory, if it represents "supply" that the Fed can do nothing about, then we are in danger of repeating the mistakes of the 1970s, in which the Fed kept chasing optimistic "potential" calculations that were in fact unrealizable by monetary policy.

And of course it matters for people. 5 percent of everybody's income is a lot of prospertity; 10 more years of slow growth adds up to a lot of lost prosperity.

Sargent on debt and defaults

2012-02-03T17:22:00.001-06:00

Tom Sargent's Wall Street Journal oped is well worth reading closely. It's a very short summary of his Nobel prize speech

As readers of this blog will probably know, I think Europe should stop bailing out bondholders of Greek and other debt. (See the Euro collection and Euro tags to the right.)

"What about Alexander Hamilton?" has always been a nagging doubt.

Hamilton famously brokered the deal by which the Federal Government assumed state debts. By doing so, he created a group of citizens with a strong interest in the success of the Federal Government. But it was a bailout of the states; it was a bailout of their creditors, many who had bought up debts cheaply. It was explicitly a case of greater "fiscal union." Perhaps this is Europe's Hamilton moment?

As Tom points out, there are some important differences. The states had borrowed money to fight the revolutionary war, not to import Porsches or build cozy crony economies and fat welfare states. U.S. Taxation was low everywhere. Even the new Federal taxes were only tariffs, amounting to 2% of GDP, not 50% and up taxation in the Eurozone. The Federal debt ("Eurobonds") was backed by directly levied Federal taxes, not by voluntary contributions or even by remittances from member states. And those direct taxes were to be legislated by a directly-elected legislature, not Brussels technocrats.

Tom points to a second episode: the state defaults of the 1830s and 1840s. Here, many states had borrowed a lot to finance infrastructure projects ("canals to nowhere?") that were not generating enough revenue to pay back the debt.

Reputation, pre-commitment and moral hazard are big in Tom's thinking and his account of the sophisticated thinking of our ancestors. The US chose to pay off its revolutionary war debt, according to Tom, to enhance its reputation and credibility as a serious nation and future borrower. But this decision led to moral hazard: states and their creditors believed the US would always bail them out. The US chose not to bail out the states (really, their creditors) the second time around. It suffered a financial crisis as a result, but put state overborrowing and default off the table for a hundred and fifty years. (When Tom talks about reputation and pre-commitment, he's not blowing smoke; he understands the equations.)

This second episode strikes Tom as a better antecedent to the Eurozone. Let Greece and the others default precisely to save the euro and European union. Now is the time to clarify that the no-bailout clause is real, and that the euro will not be inflated. A crisis is the price of not having been clear about that moral hazard up front. But the union project is too important to abandon.

There are lots more little gems in Tom's paper. The interaction of monetary and fiscal policy is one; the fact that framers spent all their time on fiscal policy, and money was, as in the constitution, considered just part of the definition of weights and units.

This post is a bit interpretive, and I'm sure I put some words in Tom's mouth here and there. He's always scholarly, informative and precise. If so, well, there's no substitute for the original.

Important Note: The comments section is running off the rails. Please be polite and stay on topic. You're welcome to disagree, or point out flaws in my arguments or facts -- actually I like that, as I learn something. But if you want to spew venom, go back to Krugman and DeLong's blogs. I'm going to turn off comments if this doesn't end asap.

Negative stimulus, 1946

2012-02-02T20:30:00.001-06:00

I ran across a fascinating article, "A Post-Mortem on Transition Predictions of National Product," in the 1946 Journal of Political Economy, by Lawrence Klein. Klein, who would go on to create the main macroeconomic forecasting models and a Nobel Prize, was confronting one of the first great failures of Keynesian economics:

We all recall clearly the headlines in last Autumn's press, declaring that "Government economists predict 8 million unemployed by 1946." ...We now find ourselves in the first half of 1946 with about three million unemployed and facing one of the greatest inflationary pressures that we have ever experienced. The economists who were warning us of a deflationary danger during the early months of the postwar transition period should have been stressing precisely opposite economic policy

Yes indeed. Government spending, or "stimulus" in the modern lingo, was certainly going to fall like a stone at the end of the war. 8.5 million young men would be dumped on the labor market. With a Keynesian mindset the forecast was obvious: we're going right back to the depression. Instead, we got sharp inflation and a boom.Where did they go wrong? This event has been covered in more depth, but let's keep reading Klein's analysis...

The customary model for prediction can be called the simplest Keynesian model...The model can be written as GNP=C(GNP)+I, where GNP = gross antional product, the function C(GNP) is the consumption schedule, and I = autonomous investment....

It is immediately obvious where this forecast failed-in the prediction of consumer expenditures,...The order of magnitude of the error involved is great, and, what is more serious, it is great enough to lead to disastrous policy recommendations. The predicted GNP of $164.5 billion should call for an inflationary policy, but this is just the opposite of the policy that was needed...

Most critics will agree that the consumption function is incorrect...At least as important as the statistical errors, however, are the errors of economic theory...[the consumption function].may be incorrect from an economic theoretical point of view and from a statistical point of view.

And after this poor Klein dithers around with statistics, the special effects of "bottlenecks," wartime, liquidity and so on. With the benfit of hindsight you can see him circling around the elephant in the room, the permanent income theory of consumption. No, returning soldiers did not follow some "schedule" relating this year's consumption to this year's income. He's so close, he can smell the elephant, but he never quite touches it. That would wait 15 years and Milton Friedman's permanent income, to be followed by Lucas, Sargent and the others who tore apart this Keynesian castle.

Why are we reading this? It's fun to go back and see how really smart people understood things at the time. Maybe it should give us some humility -- so much policy debate seems based on the idea that we know everything so well. If we understood things as well as we now see Klein understood things, would we still want to spend trillions on our best guesses? Klein is happy that the Government didn't follow the widely-recommended "inflationary" or stimulative policy advocated in 1945! If you were transported back to to 1790 and got sick, would you want to be treated by the best doctors of the day?

On the other hand, many of Tom Sargent's writings suggest our ancestors understood nuances of policy even better than we do -- or at least before the brief interlude in which Keynesians forgot everythng their ancestors knew. (Start with Tom's Nobel Prize speech. The point is not that hard to see between the lines.)

As a research economists, it's a bit frightening. There are surely such elephants in our room that we're missing, and we will kick ourselves for not really noticing them. Try not to get so close and miss the big point!

I got to Klein on a different mission. 1946 is a great data point to understand -- the great negative stimulus which coincided with a boom and inflation. I also got to this paper while digging in to the long set of historical writings that found budget constraints missing in Keynesian models. This is a big point in my writings about stimulus, but I'm not the first to notice that. More later...

Notice a Journal of Political Economy article published in August 1946 about how summer 1945 forecasts for 1946 turned out! That could never happen now, in any academic journal.

Update: David Henderson and Russ Roberts on the postwar depression that wasn't, with good Samuelson quotes.

Consumer financial protection, 1984

2012-01-31T10:07:00.000-06:00

The Financial Times reports an amazing interview with Martin Wheatley, the "head of the UK's new consumer protection watchdog."

Investors cannot be counted on to make rational choices so regulators need to “step into their footprints” and limit or ban the sale of potentially harmful products,

“You have to assume that you don’t have rational consumers. Faced with complex decisions or too much information, they default ... They hide behind credit rating agencies or behind the promises that are given to them by the salesperson,” said Mr Wheatley..

The new approach rests on research in behavioural economics that shows investors often make decisions contrary to their own interests because of their aversion to losses or unwillingness to ditch a losing strategy. It represents a profound shift in regulatory stance.

Rather than simply ensuring that consumers are provided with complete and accurate information, the FCA will be monitoring firms to make sure that the right kinds of products get sold to the right kinds of people.

I can't wait to see the Nanny State plan to help day traders to ditch those losing stocks faster.

Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook.

Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?

Sure, the market will get it wrong. But behavioral economics, if you take it seriously, predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions.

More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong.

Serious behaviorists know this. Thaler and Sunstein's "Nudge" is pretty careful not to jump from "people make mistakes" to "a benevolent bureacracy must take care of the charming moronic pesantry." Alas, fans of 19th century aristocratic paternalism, who call themselves "liberals" today, make the jump with alacrity. They love to (mis-) cite behavioral economics as cover for their interventions. As, apparaently, Mr. Wheatley and the UK "protection" scheme he will now lead.

If he were to take behavioralism seriously, the interview would reveal a deep reflection on how he was going to keep his new agency from displaying all those biases likely to lead to bad decisions.

For example, his new power to tell bank A that its products are "mis-sold" will quickly and predictably lead to bank B taking his employees out to lunch to explain how terrible bank A's products are and how it must be stopped. "Consumer protection" has quickly morphed into "protection from competitors" the world over, and the behavioral biases of regulators (salience, social networks, etc.) are part of the story. "Watchdogs" become lap-dogs.

Where are the behavioral Stigler and Buchanan? It seems high time for a thoroughgoing behavioral analysis of the functioning of government bureacracy, legislation, and regulation.

Here's some real "financial protection" advice: Look at the elephants in the room.

The first thing the average American should do is get out of a highly leveraged, very illiquid investment that poses huge idiosyncratic risk. That's called an "owner-occupied home." Rent, and put the money in the stock market. Or buy a smaller home, that you can afford. Our government is still nudging us in exactly the wrong direction

The seond thing the average American should do is save a whole lot more. Our government is pushing more subsidies for student, homeowner, and business loans, and dramatically raising the already high taxes on saving and investment. When the American consumer tried to start saving a bit more in 2008, our Government responded with massive "stimulus" whose explicit purpose was to undo this bout of national thriftiness and get us to consume more, now.

Who's behavioral here?

Update: (response to some comments).

There is a huge difference between the justifications for regulation. 1) Protecting people from fraud. This is enforcing contracts and property rights, which is an obvious function of government. 2) Protecting people from definable and remediable market failures. That's more tenuous, but still a justifiable form of regulation. Though it's dangerous, see the capture exmaples, and often backfires. 3) "Protecting" people because the beuracracy just thinks it knows how to run people's lives better than they do. This used to be called aristocratic paternalism. Now it's defended by a misreading of behavioral economics. That's what the post is about. I hope that helps. I see it's an issue worth revisiting.

Consumer financial protection, 1840

2012-01-30T14:20:00.001-06:00

I recently read again a very nice paper by Toby Moskowitz and Effi Benmelech, "The Political Economy of Financial Regulation" which studies 19th century usury laws. Usury laws limit interest rates that can be charged for loans, supposedly to protect borrowers.

It doesn't always work out that way.

Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit. And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses. Toby and Effi present a powerful case that this is what happened in 19th century America.

I like this paper also for a deeper methodological reason. Cause and effect are devilishly hard to distinguish in economics. We have many fewer good instruments or "natural experiments" than we would like. Toby and Effi build a strong case for cause and effect with patient and exhaustive circumstantial evidence. I can't cover all that in a blog post, but it's good to look for it in the paper.

Here are just a few of the fun facts.

Tighter usury laws led to less credit. People didn't easily get around them.
Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade.
Usury laws only affect the growth of small firms. Big firms do fine.

Unlike many analyses, Toby and Effi spend a lot of effort understanding why the right hand variable moves. Why do states put in usury laws?

Usury laws relax in financial crises, when all interest rates spke and even well-connected borrowers are starting to be affected.
Usury laws are stronger in states where voting is restricted to wealthy people. It's also stronger in states with other restrictions on competition such as restricted incorporation laws
Usury laws are relaxed when there are more newspapers, and when those newspapers are more active an challenging politics and corruption.

In sum, "Our evidence suggests that incumbents with political power prefer stringent usury laws because they impede competition from potential new entrants who are credit rationed."

Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...

A brief parable of over-differencing

2012-01-26T12:10:00.003-06:00

The Grumpy Economist has sat through one too many seminars with triple differenced data, 5 fixed effects and 30 willy-nilly controls. I wrote up a little note (7 pages, but too long for a blog post), relating the experience (from a Bob Lucas paper) that made me skeptical of highly processed empirical work.

The graph here shows velocity and interest rates. You can see the nice sensible relationship.

(The graph has an important lesson for policy debates. There is a lot of puzzling why people and companies are sitting on so much cash. Well, at zero interest rates, the opportunity cost of holding cash is zero, so it's a wonder they don't hold more. This measure of velocity is tracking interest rates with exactly the historical pattern.)

But when you run the regression, the econometrics books tell you to use first differences, and then the whole relationship falls apart. The estimated coefficient falls by a factor of 10, and a scatterplot shows no reliable relationship. See the the note for details, but you can see in the second graph how differencing throws out the important variation in the data.

The perils of over differencing, too many fixed effects, too many controls, and that GLS or maximum likelihood will jump on silly implications of necessarily simplified theories are well known in principle. But a few clear parables might make people more wary in practice. Needed: a similarly clear panel-data example.

547 pages

2012-01-25T19:54:00.000-06:00

As reported by the Wall Street Journal, Mitt Romney's tax return was 547 pages long. If you want to know what's completely sick with our tax code, this is it.

Demographics and stock prices

2012-01-25T16:54:00.001-06:00

Zheng Liu and Mark Spiegel at the San Francisco Fed wrote a very nice letter on demographics and asset prices, summarizing a lot of good academic work on the question.

See the graph to the left, taken from the letter: M/O is the ratio of middle aged to old, and P/E is the stock market price-earnings ratio.

It seems like a natural story: In the 1970s, there were relatively few prime-age savers around to buy stocks, and the prices fell. Starting in the 1980s to late 1990s, boomers entered their prime saving years, bought stocks and drove the prices up. And now that the boomers are retiring, they start selling, and watch out for prices! Zheng and Mark make a pretty discouraging forecast.

These facts dovetail with research (my summary here, but lots of people have made this point) that high price/earnings ratios correspond to lower subsequent returns, and low price/earnings ratios correrpond to higher subsequent returns. One alternative story is that low prices come when people expect low growth in cashflows, and high prices come when people expect better future cashflows. That story does not turn out to be true on average. So the buying and selling pressure view is consistent with those facts.

I'm still not convinced, however, for a few reasons (all completely acknowledged by Zheng and Mark -- no fight here, we're just dissecting the evidence). First, empirically, movements in stock prices are about the equity premium, how much more you expect to earn on stocks rather than bonds, not the overall level of returns. Stock prices are about the willingness to bear risk, not about saving or dissaving. If it's all about saving and dissaving, we should see bond prices and yields (adjusted for expected inflation) move right along with stock prices and expected returns. To construct a demographic theory of stock prices and returns we have to argue not that people want to save more in middle age, but that they become less risk averse in middle age. Maybe, but it's a different story.

Second, markets are internationally linked. There may not be any American savers to sell your stocks to when you retire (especially if the taxation of investment returns rises sharply). But there will still be a billion Chinese!

Empirically, you can see there are about three data points, and Zheng and Mark acknowledge playing a bit with the demographic data. Lots of other things generate the same correlation with P/E ratios. In my research, I've been emphasizing the link to economic conditions that you can also see in the P/E plot -- good prices in good times, bad prices in times of recession or stagnation.

However, this is also a more important question than people think. Stocks earned about 8% real and about 6% or so more than bonds over the long histories of data we have, starting in either 1926 or post WWII. Many people bake in the idea that we will continue to get great returns like these in the future. Many pension funds discount there liabilities at these high rates of return.

Maybe, maybe not. There are lots of stories that the expected return on stocks for the next 20-30 years could be a lower. Wider participation via index funds and 401(k) -- wider risk sharing -- is one. Demographics, whether local or global, are another. The chance that we will enter a few decades of slow economic growth is another.

"Who will you sell your stocks to when you retire?" is an important question. With limited data, thinking through the various stories to see if they make sense is the only way to make much progress.

Romer on Regulation

2012-01-23T12:06:00.002-06:00

I ran in to a lovely little paper on regulation, thinking about financial regulation, from Paul Romer.

In my thinking about financial regulation, I've been heading toward the idea that we should regulate assets, not institutions; that regulations should be few and simple; that regulations should be rules, not licenses for regulators to do whatever they want; that rights and recourse for the regulated are important limits on the abuse of even well-intentioned power; and that pre-commitment, limiting the power of regulators ex-ante to bail out ex-post is important. That view is in an earlier blog post, and in an article in Regulation. More to come of course.

Paul comes to about the opposite conclusion, in a very thought-provoking way.

Paul cites Myron Scholes' law, "Asymptotically, any finite tax code collects zero revenue," to suggest that simple clear rules will never work. He cites the FAA's regulation of flight safety and the Army's integration as successful examples in which regulators, given wide latitude but rewarded on results achieved. And he cites the OSHA as an example of the hopelessness of a rules-based approach. For example,

1926.1052(c)(3)
The height of stair rails shall be as follows:
1926.1052(c)(3)(i)
Stair rails installed after March 15, 1991, shall be not less than 36 inches (91.5 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
1926.1052(c)(3)(ii)
Stair rails installed before March 15, 1991, shall be not less than 30 inches (76 cm) nor more than 34 inches (86 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.

Paul comments:

It is tempting to ridicule regulations like these, [you bet! -JC] but it is more informative to adopt the default assumption that the people who wrote them are as smart and dedicated as the people who work at the FAA. From this it follows that differences in what the two types of government employees actually do must be traced back to structural differences in the meta-rules that specify how their rules are established and enforced. The employees at the FAA have responsibility for flight safety. They do not have to adhere to our usual notions of legalistic process and are not subject to judicial review. In contrast, employees of OSHA have to follow a precise process specified by law to establish or enforce a regulation. The judicial checks built into the process mean that employees at OSHA do not have any real responsibility for worker safety. All they can do is follow the process.

I'm not totally convinced. In part, I'm a pilot, aircraft owner, and flight instructor, so I have a slightly different view of the FAA than the average air traveler. Yes, commercial jet travel is remarkably safe. But it's not at all obvious how much of this comes from the FAA regulation, especially at the margin, and how much from technical progress in aircraft and pilot training.

The surest way to ensure flight safety is to make sure nobody takes off in the first place. That often seems to be the FAA's attitude towards the light aircraft that I fly.

For in fact the social optimum balances flight safety against the economic and personal advantages of flying. For commercial aircraft, the airline companies and the flying public are loud enough to be heard. For light aircraft, we are not. No FAA employee was ever fired for the number of flights that didn't happen, the number of pilots who gave up flying, the technical innovations that didn't happen under his watch.

And the Federal Aviation Regulations, plus the FAA's love of paperwork, can make the OSHA stair railings look positively simple. In fact, there are rules, there is right of appeal, and by and large the FAA does not have the authority to come out to your airport and shut you down if it doesn't like what you're doing. (It can, and does, dig in to the paperwork to find inevitable flaws.) And these are good things!

Some of the FAA's "safety" regulation has the opposite effect. For example, automobile engines are now more reliable than light aircraft engines. But they and their parts are not "certified," a long and expensive process. So we use what's certified. Airplane-to-airplane collision avoidance systems have been on the market for several years that cost $1000, yet the FAA's system ("ADS-B") which will be much more expensive is taking years to come out.

I'll say this for the FAA: it's all much worse in Europe. And the FAA is not corrupt. Wide latitude to make decisions as you see fit, and to selectively enforce a forest of rules, is usually a surefire recipe for corruption.

Looking forward to financial regulation, it seems inevitable that regulators, given wide latitude, and charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety. The Fed's proposals to implement Dodd-Frank (comments here) seem already very clear in that direction

Scholes' rule is fun too, but the corollary is that any society will arbitrarily expand the complexity of its regulation and the deviousness of lawyers and accountants to avoid it, until nobody actually does anything anymore and the society grinds to a halt.

So, it's a great and thought provoking read, and it's making me think a lot harder, though I'm not totally convinced.

New Keynesian Stimulus

2012-01-21T14:24:00.000-06:00

One piece of interesting economics did come up while I was looking through the stimulus blogwars.

Paul Krugman pointed to New Keynesian stimulus models in a recent post, When Some Rigor Helps.

But take an NK [New-Keynesian] model like Mike Woodford’s (pdf) — a model in which everyone maximizes given a budget constraint, in which by construction all the accounting identities are honored, and in which it is assumed that everyone perfectly anticipates future taxes and all that— and you find immediately that a temporary rise in G produces a rise in Y"...

So I guess I’d urge all the people now engaging in contorted debates about what S=I does and does not imply to read Mike first, and see whether you have any point left.

As it happens, I've spent a lot of time reading and teaching New Keynesian models.

I wrote a paper about New Keynesian models, published in the Journal of Political Economy (appendix, html on JSTOR). I haven't totally digested the NK stimulus literature -- In addition to Mike's paper, Christiano, Eichenbaum and Rebelo; Gauti Eggertsson; Leeper Traum and Walker; Cogan, Cwik, Taylor, and Wieland are on my reading list -- but I've gotten far enough to have some sharp questions worth passing on in a blog post.

Krugman continues,

That doesn’t mean that you have to use Mike’s model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment

One thing I know for sure: This is wrong. (It's an understandable mistake, and many people make it.) The New Keynesian models are radically different from Old-Keynesian ISLM models. They are not a magic wand that lets you silence Lucas and Sargent and go back to the good old days.

New-Keynesian models have multiple equilibria. The model's responses -- such as the response of output to government spending or to monetary policy shocks -- are not controlled by demand and supply. They occur by cajoling the economy to jump to a different one of many possible equilibria. If you're going to write an honest op-ed about New Keynesian models, you really have to say "government spending will make the economy jump from one equilibrium to another." Good luck!

New Keynesian models offer a fundamentally different mechanism from the IS-LM or standard storiesthat Krugman -- and Bernanke, and lots of sensible people who think about policy -- find "actually more useful."

For example, the common-sense story for inflation control via the Taylor rule is this: Inflation rises 1%, the Fed raises rates 1.5% so real rates rise 0.5%, "demand" falls, and inflation subsides. In a new-Keynesian model, by contrast, if inflation rises 1%, the Fed engineers a hyperinflation where inflation will rise more and more! Not liking this threat, the private sector jumps to an alternative equilibrium in which inflation doesn't rise in the first place. New Keynesian models try to attain "determinacy" -- choose one of many equilibria -- by supposing that the Fed deliberately introduces "instability" (eigenvalues greater than one in system dynamics). Good luck explaining that honestly!

In the context of the zero bound and multipliers, not even this mechanism can work, because the interest rate is stuck at zero. There are "multiple locally-bounded equilibria." Some stimulus models select equilbria by supposing that for any but the chosen one, people expect that the Fed will l hyperinflate many years in the future once the zero bound is lifted. Hmmm.

These problems can be fixed, and my paper shows how. Alas, the fix completely changes the model dynamics and predictions for the economy's reaction to shocks.

Or maybe not. I know the simple New Keynesian models suffer these problems. (That's what the JPE paper is about.) Do they apply to the stimulus models? I don't know yet. I certainly have some sharp questions to ask, and I don't see anything in the models I've looked at with a hope of solving these problems.

Moreover, even taken at face value, the predictions of New Keynesian models are a lot different from Krugman's advertisement that more G gives more Y.

Every NK stimulus model that I have read is "Ricardian." Government spending has very large effects, even if it is financed by current taxes. Good luck writing an op-ed that says, "The government should grab a trillion of new taxes this year and spend it. We'll all be a trillion and a half better off by Christmas." The popular appeal of stimulus comes from the idea that borrowed money doesn't transparently reduce demand as much as taxed money. But that's the iron discipline of models -- you can't take one prediction without the other. If you don't believe in taxed stimulus, you can't use a Ricardian New Keynesian model to defend borrowed stimulus. (Or you have to construct one in which there is a big difference, which I have not found so far.)

More weird stuff, from Gauti Eggertsson's introduction

Cutting taxes on labor or capital is contractionary under the special circumstances the United States is experiencing today. Meanwhile, the effect of temporarily increasing government spending is large, much larger than under normal circumstances. Similarly, some other forms of tax cuts, such as a reduction in sales taxes and investment tax credits, as suggested, for example, by Feldstein (2002) in the context of Japan’s “Great Recession,” are extremely effective....

At positive interest rates, a labor tax cut is expansionary, as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts become contractionary. Similarly while capital tax cuts are almost irrelevant in the model at a positive interest rate (up to the second decimal point) they become strongly negative at zero. Meanwhile, the multiplier of government spending not only stays positive at zero interest rates but becomes almost five times larger.

Tax cuts are contractionary? The stimulus failed because the large tax cut component dragged output down? That's new, and I didn't hear Krugman complaining! Maybe it's right, but you can see we're a long long way from simple ISLM logic. Also, it's clear that these models make a sharp distinction between zero and nonzero rates, that stimulus advocates certainly do not make.

I also notice that "deflationary spirals" are a big part of the analysis. For example, in Christiano et al.,

But, in contrast to the textbook scenario, the zero-bound scenario studied in the modern literature involves a deflationary spiral which contributes to and accompanies the large fall in output.

OK, but we have near zero short-term government rates, a 3% positive rate of inflation and far from zero corporate and long term rates. Does the analysis apply?

Back to reading. I'll post again if I get more NK stimulus insights. It may take a while. I still think it's yesterday's news. Sovereign default seems more important for the future.

Stimulus and Etiquette

2012-01-19T12:16:00.003-06:00

The stimulus wars are heating up again.

I wrote my last, and I thought best, summary blog piece "Stimulus RIP" in November 2010, (all my stimulus posts here), but a previous 2009 post seems to be behind a new outburst of blog activity. I won't get it all, but some contributors are David Glasner, Scott Sumner, Kantoos , Brad DeLong and of course, Paul Krugman

Some response seems called for.

Stimulus

Let's be clear what the "fiscal stimulus" argument is and is not about.

It is not about the proposition that governments should run deficits in recessions. They should, for simple tax-smoothing, consumption-smoothing, and social-insurance reasons, just as governments should finance wars with debt. That doesn't justify all deficits -- one can still argue that our government used the recession to radically increase permanent spending. But disliking "stimulus" is not the same thing as calling for an annually balanced budget.

Nor is it about debt financing of "infrastructure" or other genuine investments. If the project is valuable, do it. And recessions, with low interest rates and available workers, are good times to do it. That doesn't justify all "infrastructure" roads and rails to nowhere, of course. A good test: If China offers to deliver an infrastructure project at half price, but no "jobs" will be "created," do you still want it? If you say "yes, even more" than it's infrastructure. If you say "no, we need to create jobs" then it's stimulus.

The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare. Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5. Yes, endorsed by Krugman because it "feels like a job" (his back must not hurt like mine does) and by DeLong: "anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all."

The "targeted," "infrastructure," and the whole worthy apparatus to monitor the wisdom of "stimulus" spending (see John Taylor) is, in the Keynesian model, beside the point, or at best a smokescreen to befuddle the ignorant masses. It would in fact be better if the money were stolen. Thieves have high marginal propensity to consume, and they can get that "spending" out fast in an economy with few "shovel-ready" projects.

Stimulus is a remarkable proposition, because micro fallacies morph into macro wisdom. We all lambaste mayors who tax small businesses (or borrow against future taxes) to build showpiece "jobs" projects. This way lies Buffalo. Yet for the economy as a whole, stimulus says, it's true. The hurricane should have been bigger, so the government would have spent more money to rebuild. Many stimulus advocates point to WWII spending. Think about what that means: all those tanks, ships, and airplanes on the ocean floor were not a terrible economic sacrifice we paid to win a desperate war. Every ship the Germans sunk let the government buy another ship, and gain a ship and a half worth of GDP in the process!

Such paradoxes are sometimes true in macroeconomics and finance -- for example, we can individually sell stocks, but collectively we can only drive down prices. But you can see how hard the proposition is once you understand it and pull back the smokescreen-- and how delectable "stimulus" is for politicians who love to build those "jobs" projects even when they are a net drain.

On silence

I've been off this issue for a while, mainly because fiscal stimulus is so clearly off anyone's policy or economic agenda. The US is not about to deliberately borrow another few trillion dollars a year and send it down whatever rathole is handy in the name of stimulus. The Administration won't even use the word "stimulus" anymore. Europe is even less likely to do it. Krugman, amazingly, thinks Greece should be spending more.

Everyone else sees our task as avoiding a global sovereign-debt crisis.The fascinating macro economic question is why our "short run" recession seems to be turning in to "long run" stagnation and slow growth. Lack of government spending is not high on most people's lists.

So, fiscal stimulus doesn't seem worth much blogging effort to me. It's just off the menu. We might as well debate a gold standard vs. bimetallism.

The state of affairs

Stimulus still an economically interesting proposition, and there is a great deal of uncertainty about whether, when, and how well it might work. There is a huge academic literature being produced right now, as typically happens after any event makes the news.

Here are the facts. Some economic models do predict a fiscal stimulus effect. Some don't. Some of those models have huge holes in them (the standard IS LM model, which even Krugman admits is "ad hoc"). Some don't. The rather mysterious "New Keynesian" stimulus models could use a lot of investigation (More in an upcoming post.)

Even if stimulus works, when and for how long? A lot of models give more stimulus when interest rates are stuck at zero. But many advocates, like Krugman and Delong, want more government spending even for times and for countries (Greece) with high interest rates. Surely too much spending eventually leads to debt crises or strangling taxation, but when? (Then, advocates usually want inflation and devaluation, but that has a limit as well.)

The facts are far from decisive. The right says: "The government spent like a drunken sailor and we still had an awful recession. Stimulus Failed" The left says "It would have been way worse without the stimulus." History does not paint a clear picture either. GDP rose a lot along with Government spending at the beginning of WWII. GDP didn't fall like a stone at the end of WWII. Economists are producing hundreds of papers and volumes of studies for us to sort through, which I'll review in the future, but cause and effect will always be hard to tease out in economics.

So, there is a lot of uncertainty and a lot we don't know about how the macroeconomy works. That's what makes being an economist fun! There is a lot that well-read thoughtful economists can do to summarize and contribute to this debate.

Etiquette

What help do we get from Krugman to help us understand this debate, sort out the assumptions and the facts?

Here: "Lucas/Cochrane made simple, fail-an-undergrad-quiz-level, errors."
Here: "The nonsense problem" Cochrane and Luas don't have a "defensible model."
Here: "The great Lucas made a nonsense argument by any standard"
Here: "Oh, and the Cochrane-Fama thing ...there doesn’t seem to be a model behind it, just a misunderstanding of what accounting identities mean"
Here: Again, "no model".
Say's Law., Say's Law, Say's Law and "Economic Barbarism". I and Lucas are "propounding Say’s Law — the idea, refuted 75 years ago, that all income must be spent and hence that supply creates its own demand"
Here: "New Keynesians understand New Classical models, but New Classicals don’t"

This is all ridiculous, of course. No, I -- and certainly Bob Lucas and Gene Fama -- am not making the "Say's law" fallacy. We all understand the difference between identities, budget constraints, and equilibrium conditions. Should I just respond "Bastiat's fallacy" over and over again?

(The issue is how saving = investment is achieved, and what happens out of equilibrium. Keynesian models specify that "plans" depend on income, and do not have to add up via a budget constraint -- you can "plan" to consume save and pay taxes more than your income. Income then adjusts until saving equals investment. In "classical" models, "plans" are called "demands" and have to add up to income. Prices adjust to clear markets. In "new Keynesian" models, those prices are sticky. I'm simplifying drastically here for public consumption, so Brad and Paul, spare us the outburst on what a moron I am or that I didn't mention x assumption.)

"No model" is even more ridiculous. What, there is no economic model in which fiscal stimulus falls below 1.5? Or we somehow "don't have" the models in our graduate reading lists, and in the footnotes to my blog posts? "Barro, Kydland and Prescott, King and Baxter, King,Plosser, and Rebelo, Uhlig,.Taylor, don't exist?... Maybe those models are wrong. Maybe they are logically coherent but don't fit the data. But to say they don't exist is just ridiculous!

Then there are the insults and slander.The most hilarious are the doctor-heal-thyself accusations:

Krugman calls me, by name, a "Mendacious idiot"; though hilariously swearing "I've never gone ad-hominem;"
He writes that I rest on "credentials" to spout nonsense and "pull rank" or "argue from authority" -- Cochrane argues from authority, rank and credentials, Mr. I-have-a-Nobel-Prize-so-you're-a-moron?
"Chicago has both forgotten basic macroeconomics and become so politicized that when it comes to policy, people literally can’t think straight" Chicago has become politicized? (Also factually untrue. Look at our faculty list. Goolsbee works here, there are many to the left of him. We hire quality, not politics.)
He writes, in print in the New York Times, that I (we) write for "sabbaticals at the Hoover Institution and job opportunities on Wall Street?" I accept the challenge: 1040 forms at 20 paces. We'll see who gets paid how much by whom to write what.
The first of a long set of posts complainig that Bob Lucas "smeared" Christina Romer by suggesting that maybe her defense of stimulus after about two weeks on the job might have been requested by the White House. A "Smear!" Heavens!
He opines, "when it comes to Cochrane, or Brian Riedl, there’s no there there"

And Krugman is a piker in this department relative to Delong, for example calling me and others "a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash." And " so on.

There is a lot of uncertainty in macro, both theoretical and empirical. There is a huge outpouring of serious work. How does it help at all to say your side has perfect wisdom, enshrined in a roughly 1975 vintage ISLM model, and everyone who disagrees, including Lucas, Prescott, Fama, and so forth is stupid, lying, doesn't understand econ 1, thinks 2+2=5, or in the pay of wall street? A worthy analysis investigates how sensible people can come to both views, and then isolates which assumptions or facts they differ on. (Something I haven't done here for lack of space, but will return to later.)

What is wrong with these people?

I'm not the first to notice this emptiness of argument, and they're starting to be defensive. It's ok to slander and insult, because, as Krugman writes and Delong Endorses " This is not a game, and it is also not a dinner party; you have to be clear and forceful to get heard at all." It's all necessary because "Economic policy matters" .

What self-important hogwash! Life is a dinner party -- at least if your goal is the truth, and you have a bit of humility to understand our limits and still be searching for it. Didn't your mothers tell you that? "Because it matters" is precisely why it's important to acknowledge our limitations and search politely for the answers.

Note to the blogosphere: This is not how real economists discuss things. I've had great and productive interactions with Austan Goolsbee, Mike Woodford, David and Christina Romer among many other serious economists who are favorable to stimulus. Nobody calls anyone else a moron. Normal people behave this way. They can do so even if communicating via the internet.

The question is, what is wrong with the rest of us that we pay so much attention?

Well, I'm done for a while, but I will return to stimulus soon, trying to digest the outpouring of thoughtful academic work on both sides. I realize I didn't get much into the theory or facts about stimulus, but this is a reaction blog post not an encyclopedia, so that will have to wait for another day.

Romney's 15%

2012-01-18T09:12:00.000-06:00

Romney's 15% average income tax rate is all over the news, with the usual "tax the rich" outrage.

Romney pays little income tax because, hold on...Romney has little income. The guy doesn't work. He lives on his investments and campaigns for President. If I took a year off of teaching to go on a round-the-world gliding tour, I wouldn't have much income either, and would pay little income tax.

(We're all guessing here, of course -- maybe it's all crafty shelters. But who cares about Romney anyway; the issue at stake is whether the US should substantially raise rates on everyone else's interest, dividends, capital gains, or wealth itself, in addition to estate and property taxes.)

Yes, from an economic perspective, interest, dividends and capital gains are not "income." Romney should pay taxes, and at least at the same rate as everyone else. He should pay taxes on his consumption, not the returns on his investments.

A central proposition in the economics of optimal taxation is that the tax rate on capital should be zero or close to it. Like anything else in economics, there is a huge literature of ifs ands and buts, yet the result seems fairly robust. (Google "optimal taxation of capital." This is not a political statement, there are thousands of pages of equations behind it. There is a separate "optimal taxation" literature on "optimal redistribution," with some equally surprising results that I'll write about some other day.)

Intuitively, this is related to the theorem that you shouldn't tax intermediate goods, or have tariffs for moving goods around the country. Romney's income was taxed once, when he made it. It's not efficient to tax it again, because he chose to save it rather than spend it immediately on an orgy of houses, private jets, and a big vacation for his extended family.

If you made money in dollars, paid taxes, then went to Canada and got $1.20 Canadian, it would make no sense to say "you made 20 cents of income, we'll tax it." It makes no more sense to pay taxes again on money that is moved over time. We decry that Americans don't save enough, the Chinese, the trade deficit and so on. Well, if you want people to save more, stop taxing it.

For this reason, the U.S. Tax code has been slowly reducing the taxation of rates of return. Capital gains and dividends are now taxed less than ordinary income. IRAs, 401(k), 526, and a welter of other devices allow people to save and invest without paying taxes on the rates of return. (It would be much simpler to just eliminate taxes on rates of return, but then the lawyers and accountants would have nothing to do.) Dividends are finally taxed at the same rate as capital gains. Estate taxes have been slowly and chaotically lowered.

Taxes on capital and wealth also are singularly unproductive of income, and very productive of tax shelters.

It's been a slow and painful process. And now, about to be undone, for no good economic reason.

Obviously, economists need to communicate better. Economists in general need to keep reminding everyone to look at tax rates, distortions and incentives first and foremost, not taxes. Opinion writiers like Paul Krugman's post on the subject don't do the world a favor by deliberately forgetting this basic principle when it is politically convenient.

Powell's secrets

2012-01-17T16:05:00.003-06:00

Jim Powell wrote a nice Forbes article, "The Most Important Secret of a Prosperous Economy," filled with his usual brand of thoughtful historical detail. Two paragraphs caught my eye,

Consider, for example, what it’s like trying to start and operate a legal business in Singapore (atop the World Bank’s Doing Business 2012 report on 183 countries) compared with Chad (at the bottom of the list). In Singapore, starting a legal business involves only 3 procedures, whereas in Chad there are 11 procedures. The process takes 3 days in Singapore, 66 days in Chad. It takes 26 days to obtain a construction permit in Singapore, 154 days in Chad. The filing fees, taxes and other costs of starting a legal business are 0.7 percent of per capita average income in Singapore, a dramatic contrast with Chad where such costs amount to 208.5 percent of per capita average income.

In Singapore, an estimated 84 hours are required each year to maintain tax-related records and prepare tax returns, versus 732 hours in Chad. Total taxes consume 27.1 percent of corporate profits in Singapore, 65.4 percent of corporate profits in Chad. Importing a container of goods costs $439 in Singapore, $8,525 in Chad. Exporting a container of goods: $456 in Singapore, $5,902 in Chad. Resolving a bankruptcy takes 9.6 months in Singapore, 4 years in Chad. In Singapore, the recovery rate (cents on the dollar) from a bankruptcy is 91.3 percent, but the recovery rate is zero in Chad. Is anyone surprised that per capita GDP is much higher in Singapore ($50,714) – about 55 times higher – than Chad ($920).

(The World Bank Report itself is a hilarious example of boosterish, glass-is-5%-full NGO writing. You'd think the whole planet was on a steady march of virtuous free-market reforms. But thanks for the data!)

As we know, this doesn't cover the half of it. In a country regulated to death like Chad, I can't imagine that each of those 11 procedures comes easily as soon as you fill out the paperwork. The dark side, which the World Bank can't talk about, is just how many bribes and connections you need to make all this work.

This little story bears on the "micro vs. macro" question for our current troubles. "Macro" explanations revolve around deficits, money supplies, and so on. "Micro" is... well, like Chad. Surely, Chad's problems will not be solved by stimulus.

In our policy debates, we focus far too much I think on the explicit tax rates and easily measured regulations. "Macro," deficits and interest rates, are easier still. The dark side of micro stagnation is just too hard to measure. That doesn't mean it isn't there. Running a business in the US isn't that easy anymore either.

DeLong on Friedmans and Freedoms

2012-01-16T08:43:00.002-06:00

Brad DeLong put up a post on Milton and Rose Friedman's Free to Choose so succinct, so outrageous, and so revealing, it merits breaking the "Don't respond to Brad" rule. Here it is, in its entirety:

There are, I think two important things you should note when you start reading Friedman and Director Friedman's "Free to Choose". The first is that it was a book that was written 30 years ago. The second is that the Friedmans believed that they were fighting against the tide of history. They thought--in 1980--that liberty and prosperity were in retreat worldwide, and had been in retreat for at least fifty years."

This strikes us--this strikes me at least--as profoundly odd. When you ask me what "freedom" means, I tend to go back to Franklin Delano Roosevelt's four freedoms:
Freedom of speech
Freedom of religion
Freedom from want
Freedom from fear
When I think of major impingements on freedom, I don't think of the things that the Friedmans point to in 1980 as evidence that freedom is in retreat. I see 1980 as coming at the end of the fastest and most complete 50-year expansion of freedom, democracy, and prosperity the world had ever seen.

When you ask me what "freedom" means, I tend to go back to "life, liberty and the pursuit of happiness." Yes, indeed, freedom of speech and religion, and also the freedom peaceably to assemble, and to petition my Government for a redress of grievances. The freedom to be secure in my person, houses, papers, (hard drive) and effects, against unreasonable searches and seizures. Due process when the Government accuses me of something or wants to confiscate my property. The freedom to own property, transact it as I see fit; the right voluntary to exchange property and labor with another. The freedom to travel, live, and work anywhere in the world.

"Freedom" means not being told by force what to do. In a peaceful society with functioning police and courts, in which private disputes are subject to the rule of law, the first and most important freedom is from government interference.

(Roosevelt was, by contrast, talking about a war. My complaint is with DeLong, not in this case with Roosevelt. "Freedom from want and fear" mean something different in the Warsaw ghetto than if we're talking about the social security inflation-adjustment formula. Brad uses this quote in the context of the Friedmans and peacetime economic policy. So am I.)

Freedom of religion and of speech are rights, of individuals against interference by their government. By putting "freedom from want" after the first two basic rights of a democratic society, this quote elevates "freedom from want" to a similar right, against the Federal Government, and thus against your fellow citizens.

No. "Freedom from want" is the result of a prosperous, free society. The first Amendment does not grant a right to a check from the Government. "Freedom from fear" also applies to the Schecter brothers' fear that the National Recovery Administration might shut down their business for selling chickens too cheaply.

(I can foresee the inevitable calumny: "You free-marketers are all heartless, you just don't care." No. We care more. We want a system that actually delivers freedom from want.)

Brad saved the best for last. Read it again (my emphasis):

I see 1980 as coming at the end of the fastest and most complete 50-year expansion of freedom, democracy, and prosperity the world had ever seen.

"The end??!!"

Here are a few "freedom, democracy and prosperity" events Brad seems to have missed since 1980:

The Reagan and Thatcher revolutions, including deregulation, tax reform, victory over inflation and inauguration of a 20-year economic boom.
A billion Chinese released from abject poverty. (Hint to China: read Capitalism and Freedom next.)
A billion Indians, also starting to join the modern world, having begun to overturn their Keynesian / English-socialist model.
We won the cold war. East and West Germany reunited. Eastern Europe freed.
The number of democracies, for example as scored by Polity, doubled since 1980. Many in Latin America and Africa too.

1980 was indeed an end. It was an end to US and UK inflation -- the result of mindless "stimulus" -- and the end of widespread acceptance of simpleminded Keynesian economics. It was the end of a brief interlude of unquestioning belief in the power of the Federal Government to solve all problems. It was the end of stagnation in the US and UK.

1980 was an inflection point for the advance of freedom, not its end! Yes, some of the Friedmans' dark worries did not pan out. Why not? Because people read the book! The Friedmans were fighting against the "tide of history." And turned it back.

"Complete??!!" We have a long way to go, and we've been heading backwards in the last few years, on all indices of economic and political freedom. Our 30 years of liberalizations may indeed now be coming to an end. The economic and political ills of the 1970s seem to be returning.

I'll agree with Brad on one thing -- It's a great time to read the book.

News flash: Bernanke not clairvoyant

2012-01-14T17:10:00.001-06:00

Last week was full of the shocking revelations in newly released Fed minutes. Bernanke and co. didn't foresee the housing crash and banking crisis! See coverage in the New York Times and Wall Street Journal.

The Times can barely conceal its "how stupid were they" glee.

The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. ...But the officials...gave little credence to the possibility that the faltering housing market would weigh on the broader economy,... Instead they continued to tell one another throughout 2006 that the greatest danger was inflation...

Justin Wolfers says the lack of foresight is "embarrassing,"

“It’s embarrassing for the Fed,” said Justin Wolfers, an economics professor at the University of Pennsylvania. “You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets.”

“It’s also embarrassing for economics,” he continued. “My strong guess is that if we had a transcript of any other economist, there would be at least as much fodder.”

(I hope for Justin's sake that his quotes were as usual mangled and taken out of context.)

The Journal piles on. Cassandras were ignored: "A handful of Fed officials warned of trouble brewing." The other "Fed officials were expecting a manageable slowdown in the housing sector, with little damage to the financial system or broader economy." And heavens, they even had "praise for outgoing Fed Chairman Alan Greenspan."

Well, that was fun. But what's the point, dear Times? We just need to put "smarter" people in charge and all will be well?

The real lesson is this: The smartest people in the room didn't -- couldn't -- see it coming. The smartest people in the room won't see the next one coming either.

Nobody can systematically predict the financial future a lot better. If they could, they'd be rich enough to bail out the National Debt.

Sure, some people warned of this event. But half of them won't see the next one. The other half have already predicted 5 more crises that never happened. The project "we'll just find someone a lot smarter or wiser than Ben Bernanke" is hopeless!

It's not embarrassing to my economics. The main prediction of market efficiency is precisely that nobody can systematically see market movements and bank runs ahead of time. Efficient markets are not clairvoyant markets. That prediction seems rather brilliantly confirmed!

This matters. We have doubled down on the idea that we can appoint All Powerful Regulators to presciently spot "bubbles" and "imbalances" before private forecasters and the harsh judgment of financial markets do so, and then regulate away the risks. This strategy has already failed at least three times, after the crisis: The SEC didn't notice Bernie Madoff; the CFTC didn't stop Jon Corzine, and the entire European bank regulatory apparatus failed to notice that sovereign debt might be risky.

This story is embarrassing, yes. But it's most embarrassing for the Times and other believers in the idea of clairvoyant, all-powerful discretionary regulators. It's not at all embarrassing if you think Fed officials are as human as the rest of us -- and that safety comes from better rules of the game, not finding just the right soothsayer to run the show.

What zero bound?

2012-01-13T08:30:00.000-06:00

German bond yields turn negative, as reported in the Wall Street Journal.

Source: Wall Street Journal

Negative interest rates are a big puzzle. Easy stories miss the point: "flight to quality," "need for collateral," etc. Those stories don't explain why bonds are worth more than money. There's no more quality or better collateral than cash!

So why would anyone suffer a negative rate on government bonds when they can hold cash instead?

For some of us it might make sense. Cash is clunky, dangerous and expensive to put under a mattress. Many banks now charge for the privilege of depositing. So an individual might prefer a very slightly overpriced government bond to cash.

But a bank has a better option. Why not just hold reserves? Reserves are like cash, and as safe and liquid (more so) than government bonds. I might have guessed that only people were buying these bonds. It seems I'm wrong (unconfirmed rumor) -- banks are buying and holding the bonds.

So why would a bank hold a bond at negative interest rate rather than hold reserves? Sometimes there are arcane technical, accounting or regulatory reasons, but so far nobody I've talked to has identified one here.

The best story I've heard so far, suggested by one of the smart students in my MBA class, is this: It's a bet on Germany leaving the Euro. If Germany leaves the Euro, it is likely to redenominate its bonds and so pay off in new DM. The ECB is likely to leave reserves in Euros. So, if you want an asset that will pay off in new DM after Germany leaves the Euro, German government bonds are a good bet.

That story pierces the zero bound. There really is no limit to how low bond yields can go if you think bonds might be paid off in a better currency than the one you can stuff in your mattress.

It sounds a little outlandish, and the chances that Germany leaves the Euro in 6 months seems pretty low to me. Still, it's a nice story. Does anyone have a better one? Remember, you can't answer why bonds look so good -- you have to explain why bonds are a better asset than reserves, for a German bank to hold!

Hungarian Outrage

2012-01-12T13:01:00.001-06:00

I stumbled across this lovely little post from Hungary, titled "This is why I don't give you a job"

It's full of classic unintended-consequence reminders for economists. For example, protecting people by not letting employers fire them means that people don't get jobs in the first place.

It has some good reminders for the US as well.

Unemployment is still a huge problem. Policy after policy is advanced to do something about "jobs." Yet, like Hungary, our Government puts all sorts of barriers in to place that discourage employment. Payroll tax, income tax, benefits regulation, workplace regulation, to say nothing of the tender ministrations of the nlrb, eeoc, osha, immigration and so on. "Get out of the way" sounds simplistic, but there is a lot IN the way. I'd love to see a comparable, accurate post for the US. (Maybe I'll write it)

This thought also informs the "Macro vs. Micro" debate. Many macroeconomists, well exemplified by Bob Hall's AEA presidential address and subsequent work, are worried about the "zero bound" on interest rates. Because nominal interest rates can't fall (much--see German bonds) below zero, we can't have a real interest rate lower than the negative of the inflation rate, or less than about -3% right now. That is a potential "wedge," a distortion in the economy, and policies from fiscal stimulus (Christiano, Eichenbaum and Rebelo for example) to a time-varying tax on consumption (Correia, Nicolini, and Farhi for example) are proposed to deal with it.

But is this the first-order, most important "wedge" distorting the decision to hire more people? Is a -3% real rate really the Big Problem in our economy? Or are the manifest financial, legal, and regulatory barriers to hiring people a larger distortion in labor markets? I haven't jumped on the zero bound bandwagon, in part because my finance background leads me to look more at credit spreads than the level of short-term government rates, but also partly on a suspicion that the really big wedges lie elsewhere. As they surely do in Hungary.

(Hungary is a beautiful place by the way. I enjoyed three weeks in Szeged in 2010 while flying in the world gliding championships, getting to see the countryside a little closer-up than I had planned. My heart goes out to the wonderful people I met there.)

The World's Biggest Hedge Fund

2012-01-11T11:52:00.000-06:00

The world's largest hedge fund paid $79.3 billion dollars to its main investor last year, as announced to the press and reported by the Wall Street Journal this morning.

It followed classic hedge-fund strategies. It's leveraged about 55 to 1, meaning that for every dollar of capital it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that money to make aggressive bets in long-run government bonds, as well as strong speculative positions in mortgage-backed securities and direct distressed lending. Lately it's been putting bigger bets on loans to Europe and currency swaps. (Balance sheet here.)

The payout was actually conservative, as it reflected only the greater interest payments earned on its portfolio of assets and realized gains, not the substantial unrealized capital gains it made over the last year as long-term bond prices rose.

Who is this miraculous fund? Why our own Federal Reserve of course!

Is this good or bad?

One argument for "good" was made famously by Milton Friedman. Commenting on central bank's interventions in currency markets, he pointed out that the central bank, like any trader, contributes to stability of asset prices if it makes money by trading. If you successfully buy low and sell high, then your actions raise prices in bad times and dampen them in good times. The usual practice of defending currencies and then giving in and devaluing them has the opposite effect.

By that measure, our Fed scores well so far. (I'm presuming here that price stability is desirable, which purists may quibble with, but let's not go there right now.) On the other hand, we also know not to evaluate long-term portfolio performance with one good bet.

There is also no return without risk. Any trader who makes a superbly good return in one period is taking a risk of poor returns in the next. When (not if, when) long-term interest rates rise, the Fed will lose money on its portfolio of long-term bonds. If the economy gets worse, it will lose money on its credit risk portfolio. And so on.

Taking big portfolio risks is quite a change for the central bank. Traditionally, a central bank issues currency and reserves and holds very short-term government or high-rated private debt. It earns a liquidity spread which it rebates to the Treasury. It does not take on substantial term or credit risk, and therefore it does not expose the Treasury to the possibility of losses.

(Some people think that central bank capital or portfolio losses don't matter. After all, it can always print money to pay its bills. That view is a fallacy. When the Fed needs to contract the money supply or raise interest, it needs assets to sell. Losses on its investment portfolio must eventually be made up by extra taxes. Benn Steil explains in more depth here and I'll come back to this issue if the comments section lights up.)

How much of a problem is the Fed's risk-taking, though? In terms of overall debt and deficits, the Fed does not pose that much of a threat. Or, perhaps I should say, other things are worse. The Fed's balance sheet is "only" $3 trillion dollars. Even if it lost half of its assets, $1.5 trillion is one year's worth of Federal deficits, 10% of GDP, or 10% of the national debt. Losses on the Fed's portfolio are not going to bankrupt the country or send us to hyperinflation. The Treasury can sell bonds and give them to (sorry, "recapitalize") the Fed, and then raise taxes to pay off the bonds. (That said, it would be nice to see a "stress test" on the central bank. Doctor, heal thyself.)

The real danger, then, is political, not financial. Imagine the fallout if the Treasury has to bail out the Fed to the tune of a few hundred billion dollars. The Fed would certainly lose a lot of independence.

Current thinking about monetary policy values the independence of the central bank. An independent central bank is a way for the government to precommit ex-ante that it won't try to goose the money supply ex-post around elections.

But the price of independence is limited authority. You cannot, in a democracy, have appointed officials with very long tenure writing checks to voters, allocating credit to specific industries, choosing winners and losers, or signing up the Treasury for trillions of dollars of tax liability. The Fed cannot drop money from helicopters as Milton Friedman once recommended; that's called a transfer payment. The Fed can, in theory, only buy and sell safe securities of equal value. As dysfunctional as Congress and Administration may be, taxing and spending are their job, as they face the voters.

Of course, Federal Reserve actions have always had fiscal consequences. For much of history, the main role of central banks was to lower the interest rate on government debt, by making that debt more liquid. And its "independence" has always been a relative thing as well. So as in many things, there is a sliding scale. But our Fed has certainly moved dramatically in the direction of actions with important, direct fiscal consequences. It must bear some cost of less independence as a result. We'll see what that is.

But potential portfolio losses strike me as a tip of the iceberg of actions that threaten the Fed's independence. The Fed participated in bailouts of specific companies and industries. It allocated credit to specific markets. In its expanded role as regulator it will be telling more and more banks how to run their businesses. It is now speaking more and more loudly about tax and spending policy, such as advocating mortgage bailouts. Its is setting "financial policy" more than "monetary policy."
The Fed is not likely to remain as independent in this expanded and very political role.

One thing is clear -- our monetary policy and central banking institutions are evolving fast.

Goolsbee on budgets

2012-01-09T09:32:00.001-06:00

My colleague Austan Goolsbee wrote a thoughtful Wall Street Journal Op-Ed last week titled "Washington isn't spending too much." I agree with more of it than you might think -- though with a few important asterisks.

The last paragraph caught my eye:

"The election should lay out each candidate's fiscal grand bargain and growth strategy. Let us compare them. They matter. This could make up the heart of a historically important presidential contest."

Yes indeed. But I don't think Austan's partisan tone is justified -- he was criticizing Republicans in Iowa. This could have been written by the Ron Paul campaign, followed quickly by acid comments that "tax the rich" is not a "fiscal grand bargain" with any hope of closing the long-run budget gap, and neither it nor more Solyndras are a "growth strategy" as economists understand long-run growth.

Here's an optimistic interpretation: Austan advises the Obama campaign. Perhaps he's dropping a hint that the campaign will unveil that grand bargain -- with a plan to get it through Congress -- and a serious growth strategy. If they do, they'll win the election and save the economy.

Austan also gets it absolutely right that

"The true fiscal challenge is 10, 20 and 30 years down the road. An aging population and rising health-care costs mean that spending will rise again and imply a larger size of government than we have ever had..."

My only quibble is that this challenge may not be so far "down the road" as Austan supposes. Bond markets panic when they see danger ahead. (Lots more here.)

The more controversial question is Austan's view that our current enormous deficits are just due to the recession, not unusually profilgate spending, and the budget will quickly recover once the economy recovers.

John Taylor took Austan to task on that question, pointing out that the Administration's February budget proposal showed no reversion to normal spending even as the economy recovers. I think John's being a little harsh here. After all, the budget was quickly ignored.

But you're here for economics, not personalities. How much of our deficit is just "normal" response to an unusually deep recession? Will the deficits fade away quickly as the economy recovers? Is spending really not a problem?

Deficits do and should rise in recessions. Tax revenues fall in recessions. A family that runs in to hard times -- business doing badly, losing a job, etc. -- should dip in to savings, or even borrow to keep expenditures relatively constant, and pay that back when good times return. Governments are the same. This is uncontroversial "consumption smoothing" and has nothing to do with attempts at "stimulus." You may -- as I do -- think that government is spending grossly too much overall, but that's a different question than the timing of that spending.

But how much? Is this the story, or is our Government off on an ill-advised shopping spree during these hard times?

Austan cites "automatic stabilizers"

"Most of the increase in the deficit during a downturn doesn't come from new policies in Washington. The deficit rises because both spending and taxes automatically adjust when the economy struggles. Unemployment insurance payments rise and more people qualify for Medicaid and food stamps. Incomes fall so people pay less taxes"

This, as far as I can tell, is not quite true. Here is the CBO's "cyclically adjusted deficit"

Source: http://www.cbo.gov/ftpdocs/114xx/doc11471/05-27-AutomaticStabilizers.pdf

Quoting from the CBO, "The budget balance without automatic stabilizers is an estimate of what the surplus or deficit would be if GDP was at its potential, the unemployment rate was at a corresponding level, and all other factors were unchanged." Now, one can quibble with their calculation, but the "without automatic stabilizers" deficit is not even close to a flat line!

Austan is close to right however. It is true that our Government typically chooses to run larger deficits in recessions. It is also true that our current deficit choices are not out of line from the historical pattern, given the depth of the recession. Here's a graph to make that point:

Surplus/deficit and output gap (GDP - potential), as percent of GDP

The red "gap" line is the percentage difference between GDP and "potential GDP." (I don't put much stock into the "potential" concept, but it provides a nice trend line.) The blue line is the Federal surplus or deficit, also as a percent of GDP.

You can see that deficits regularly get much bigger in recessions. Roughly speaking, the deficit movement is just about equal to the GDP gap -- if GDP falls $100 billion, the deficit increases $100 billion. Our deficit, about 10% of GDP, corresponds to a 10% fall in GDP, consistent with the usual pattern.

So, Austan is saying, in the tight confines of the WSJ's word count, that when the GDP gap (red line) recovers, if the Goverment follows the same choices as in the past, the massive deficits will largely disappear (blue line).

How do I keep worrying?

First, we will still have racked up an impressive debt. Each year of deficits equal to 10% of GDP adds 10 percentage points to our debt/GDP ratio. Greece is out there not too far away. Even if the deficits pass, we still have to pay off the debt...Just as the "long term" problems settle in.

Second, look at the longer-term trends. 1969-1982 saw a steady deterioration in GDP and steady widening of the deficits. The strong growth in GDP from 1982 to 2000 corresponded with our first actual surpluses in a quarter century. But 2000 to now is starting to look suspiciously like another growth slowdown. If this is 1975 again, how long until we see 1999?

In other words, what if GDP does not quickly recover to "potential?" Here's a graph to make the issue clearer.

The green dashed line is real potential GDP. You can see that actual GDP has fell about 10% below this trendline -- and is sitting there. You can see huge increase in expenditures -- the rise in the red line by nearly 10 percentage points. Expenditures are sitting at 25% of potential GDP. The huge fall in tax receipts is also striking, and they're stuck too. (Tax receipts depend on more than GDP. In particular, you can see the effect of the two big stock market declines in 2000 and 2008.)

To get GDP back to the trend line, we need 10 percentage points of extra growth, on top of the 2.5% per year or so of trend growth. That's two years of 7.5% growth, which nobody is forecasting any time soon. This "catch-up-to-trend" growth has been the pattern of past business cycles. But what if we keep stumbling along at 2.5% - 3% growth for many years, racking up trillion dollar deficits each year we do so?

Third, to make it just a little more scary, notice the subtle flattening of the green "potential" line. Trend growth itself is slowing down. The trend grew at 4% in the 1950 and 1960s, slowed to 3% through 2000. It is 2.5% in the 2000s and the CBO's forecast is down to 2.3% for the 2010s.

Back to the family analogy: Yes, dip into savings or use the credit cards if you lost your job, but a new one is all lined up for 6 months from now. But maybe this family is facing a long and uncertain spell of unemployment, and it's going to end up working at Wal-Mart for a lot less money than before. Racking up debt with alacrity isn't such a good idea in that case.

So I think both Austan and John are right: Yes, this Administration (and Congress') spending response to the recession was not much different than previous ones. But it does not follow that long-run discretionary spending and debt accumulation are not a huge problem, even before the entitlements disaster hits. We may be looking at the long run!

Which brings us back to the beginning. "A fiscal grand bargain and growth strategy" really are important, perhaps more than Austan had in mind when he penned those poetic words! Catching up to trend, and then bending the trend upwards, will take some deep changes in how we do things.

Should Greece Devalue?

2012-01-05T18:03:00.002-06:00

Two weeks ago I wrote the following in a little Bloomberg column about the Euro

Defenders [of devaluation] think that devaluing would fool workers into about of “competitiveness,” as if people wouldn’t realize theywere being paid in Monopoly money. If devaluing the currencymade countries competitive, Zimbabwe would be the richestcountry on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budgetand economic troubles. Why do economists think Greek politiciansare so much wiser?

This paragraph set off a little kerfuffle in the Cochrane-is-a-moron section of the blogosphere. I won't respond in detail, because I presume you're more interested in economics than what anyone thinks of anyone else's intelligence.

But the paragraph was mighty distilled, and the evident interest in the question suggests a little fuller examination of whether devaluation is a good idea or not for a country like Greece, and trying to understand why people come to such different views.

I think I can sum it up this way: Devaluation is like a cigarette. The Keynesian camp basically says, "Boy, a cigarette would perk me up right now."' Modern macroeconomists (I'm looking for a good name -- "Dynamic?" "Intertemporal?" "Equilibrium?" Really everybody else, including new-Keynesians) basically say "Maybe, but smoking is a really bad lifestyle decision." We think of policies as rules, not decisions.

The following discussion resembles that between a teenager and the parent who found a pack of cigarettes. It sounds like facts are at issue -- just how good does it really feel, just how long does it take to get addicted, how bad are the long-run effects -- but there is a deeper difference in perspective, which is why the arguments are a lot more heated than the simple facts suggest.

So, just how good is a cigarette anyway?

Devaluation works if prices and wages don't adjust. If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don't change, then Greek goods are cheaper and Greece will produce and export more. Similarly, inflation can goose output a bit. For example, if prices go up faster than wages, then companies will hire more workers and make more goods. (Standard disclaimer: I'm simplifying dramatically. Don't write that I'm an ignoramus because I can't get the whole modern theory of the Phillips curve into one sentence of a blog post written for a popular audience.)

So, sometimes devaluation or inflation work, at least temporarily. We've known this for a long time. In his Nobel Prize address, Bob Lucas cites Hume in 1752. "Temporarily" is an important qualification. We all agree (I hope) that money is neutral in the long run. Inflation eventually catches up to devaluation. Wages eventually catch up to prices. So even here, the question is just how long the high lasts before the hangover sets in.

And devaluation and inflation often don't work, or are indeed counterproductive. The US and many other countries in the 1970s experienced stagflation -- devaluation and inflation accompanied by worse economic performance. Most economic basket cases -- Zimbabwe was my example -- are junkies, continually inflating and devaluing. Most really successful countries -- Switzerland -- are famous for strong currencies. We've known that for a long time as well.

When does devaluation work? The most important consideration suggested by modern macroeconomics is whether the devaluation or inflation is expected or unexpected. This is the heart of Milton Friedman's famous AEA presidential address, and Bob Lucas' and Edmund Phelps' Nobel prizes. (Standard disclaimer.)

This will likely not work: the Greek government declares that on January 1 2013 it will change from Euros to New Drachmas at 2:1. I think we would all predict that "devaluing" in this way would have exactly the same effect on real prices and wages as joining the Euro did: none. On Jan 1 2013, prices, wages, contracts, bank accounts, etc. are just multiplied by 2 and a "D" replaces the "E" in front of the number. Whatever "price stickiness" means, this isn't it.

If the Greek government went on, "and then we will devalue the Drachma relative to the Euro by 5 percent per month," it still would have little real effect. With that announcement and a year to plan, Greece would simply return to an economy familiar to anyone who lived through the 1970s, steady 5% wage and price inflation.

The trick for Greece, in its current situation, is to change to a New Drachma, and convince everyone that new Drachma will have a stable value. Then, it has to surprise everyone by devaluing, or devaluing more than they expected.

That will be difficult to arrange. It could easily backfire. People could expect much more inflation and devaluation than the Government had planned. Money could fly out of the country, interest rates spike, and a panic wage and price inflation take off. Then Greece would get stagflation, not a boom.

Devaluation also "works" by engineering wealth transfers, from lenders to borrowers. But you have to surprise the wealth in order to transfer it.

So, devaluation is not an "always and everywhere" proposition. Yes, if the US were to announce that we are pegging the dollar at $2 per euro, and the ECB went along with this policy, it's a good bet that prices and wages would not adjust overnight. Dollar goods would be cheaper in Europe, and the US would export more and import less for quite a while. Countries, who already have their own currencies, a good reputation, and stable values, can devalue unexpectedly and boost exports and output. It does not follow that a return to the Drachma and devaluation will work for Greece.

The experience of small countries around the Eurozone is also not immediately applicable. They already have currencies. The combination of leaving a currency union, establishing a new currency and immediately devaluing it does not have much precedent. And for every Iceland, where devaluation helped, there is a Hungary, where it does not seem to be producing riches.

I don't deny that it could be done. But it's not so easy as the devaluation camp makes it sound.

But that's not even the main issue. How did I let the teenager drag me in to talking about how good it feels to smoke that first cigarette? Back to the nagging parent: is smoking a good lifestyle decision?

Is it better over the long run for a country like Greece to have its own currency, and routinely resort to devaluation and currency depreciation when its economy is in the doldrums or the government is discovered to have overborrowed? Or is it better to stick with the Euro, and rule that option out? Greece has plenty of experience with inflation, devaluation, and default. Much of the world was on a binge of inflation and depreciation in the 1970s. It didn't work out so well.

This is where modern macroeconomists and Keynesians start talking different languages. Modern macro discussions are full of words like "precommitment," "rules vs. discretion," "dynamic efficiency" that are absent in the cigarette-by-cigarette, live-for-today-for-in-the-long-run-we're-dead mode of Keynesian thinking.

Just one example: Before Greece joined the Euro, it paid very high interest rates. When it joined the Euro, all of a sudden it was able to borrow at German interest rates. It did, massively, as we know. Porsches went South, and pieces of paper flew North. Greece boomed. If the money had been properly invested, Greece would still be booming. The money was wasted, but the opportunity was there.

Now, why did joining the Euro give Greece this opportunity to borrow at low rates? Cynics say, because the Eurozone meant eveyrone thought Germany would bail them out, as people correctly expected the US to bail out Fannie and Freddie. But even I am not that cynical. The Eurozone was set up, remember, specifically denying sovereign bailouts.

A second explanation seems more plausible to me: by joining the Euro, Greece precommitted against devaluation. It could no longer take the easy way out. If the economy got in trouble, Greece would feel much more pressure to fix it, not to rely once again on a quick bout of devaluation. If the government got in trouble, it would have to deal with a messy default, not a quick depreciation. And the Eurozone makes that default harder than Greece's many previous sovereign defaults.(A short history by Benn Steil here.)

Nonsmokers get lower health-insurance premiums. Non-devaluers get cheaper loans. Precommittment has real benefits. We've known that for a long time too, at least since Ulysses had himself tied to the mast so he could hear the sirens.

Furthermore, countries like Greece with chronic devaluation and inflation routinely resort to capital controls, price controls, exchange rate controls and other interventions to prop up their currencies. Junkies start stealing. These steps ruin small open economies.

There is still room for debate. At least now we have both views on the table, and you see that national currency with occasional devaluation vs. precommitting against devaluation and staying in the Euro is not such an easy question. Reasonable people can disagree. Unreasonable people can disagree more.

A lot of the answer is also political, not purely economic. Does a country have solid enough political institutions so it will use devaluation only when really necessary, and not to get out of stupid policies which it really ought to fix instead? Does the teenager really have the willpower to only smoke occasionally? Do you trust the patient to self-administer the morphine? That's part of a bigger political worldview on whether you trust the benevolent discretion of politicians or whether you think they need to be constrained by strong rules and institutions.

I come down on the latter side of the fence, but mine is most assuredly an opinion, based on thinking through all these considerations, not a Fact Of Nature.

Whew, I tried to get a lot in those 4 sentences!

The VAT, a libertarian dilemma

2012-01-04T11:43:00.000-06:00

Dan Mitchell wrote an interesting op-ed in the Wall Street Journal (Cato link for those without WSJ access), highlighting a great libertarian dilemma: is a consumption tax (VAT or similar) a good thing?

Every bit of economic analysis says yes. Economists hate distortions, taxes that lead to bad economic behavior. Our tax system is full of them. Broaden the base, lower the rate, tax consumption not savings, dramatically simplify the code, and you can get the same revenue with much less economic damage.

A political argument disagrees: An efficient tax code can also raise a lot more revenue. Dan opposes the VAT (and similar consumption taxes) on that grounds. Yes it looks good to start, but politicians will soon raise the rate to the sky and spend the results. (Becker and Posner have also tackled this one several times.)

It's a strking dilemma: should we keep an atrocious tax system to limit the size of government? Is there no way to get an efficient tax system and a limited government?

Implicit in Dan's argument is a deeply pessimistic view of our Government: sooner or later, Congress will get to the top of the Laffer curve of a given tax structure. (The top of the Laffer curve is the point where the government is getting the most possible tax revenue. If the government raises tax rates any more, people work less, hire lawyers and lobbyists to evade taxes, businesses move offshore or just don't get started, and so on. The government can end up with less total money even though tax rates are higher.)

Most economists seem to disagree that we are at the top of the Laffer curve. They think Congress has not squeezed every drop out of the current tax code, so they would place more hope in future Congressional restraint. In their view, Europe first decided on a welfare state and then decided how to fund it, not the other way around.

I'm almost as pessimistic as Dan. Sure, raising tax rates can generate more revenue for a few years. But most economic analyses don't look at the long-run, growth effects of tax distortions. The full disincentive effects don't show up for years. If taxes just lower growth a few fractions of a percent, that soon compounds to drastic reductions in income and tax revenue.

The U.S. Federal income tax seems to take in about 18% of GDP with top rates anywhere from 35% to 90%. And the disincentives are bigger than you think. They result from the full sum of federal, state, local, estate, sales, etc. taxes. Greg Mankiw figured his marginal tax rate at 93% -- and he forgot sales taxes. (A bit more on long-run Laffer curves on p. 20 here)

But I'm not not quite that pessimistic. Perhaps I'm just being soft hearted, but I surely hope our political system is not quite so broken. On the other hand, it seems naive to simply count on self-restraint to keep spending under control if the Laffer curve all of a sudden is less painful.

This whole question begs for a lot more serious thought:

What is the long-run Laffer curve tradeoff, really? How much do distorting taxes affect growth, and hence long-run revenues? Is our government really close to the top of the long-run Laffer curve?

Economic distortions are not exactly the same as revenue reductions. If we accept the dark view of Government, how do we design a tax system that minimizes economic distortions, yet keeps the top of the long-run Laffer curve at, say, 20% of GDP? That is a fun optimal-taxation optimization problem. Surely the current abomination is not the answer to that question!

In one sense the top-of-the-Laffer curve view is demonstrably wrong. Dan argues that the government grabs as much revenue as it can given the current tax system, but it can't easily change the tax system. If so, it would have already enacted a VAT! Is there hope for similar hard-to-change constraints on overall tax revenue within a better system? Can we pass an effective law that says revenue may be no more than 20% of GDP?

What are the relative welfare effects of a government that is too large vs. a distorting tax system? Maybe firing all the tax lawyers accountants and lobbyists is worth putting up with a slightly bigger welfare state?

Any PhD students out there looking for thesis topics?

Three kinds of regulation

2012-01-02T11:09:00.001-06:00

I am often asked, "doesn't the financial crisis mean we need more regulation?" It's one of those maddening questions, because the answer is "that's the wrong question," which gets you nowhere.

For regulation is not "more" or "less," something you just pour into a cup until you've had enough like a good beer. Regulation is most of all "smart" or "dumb." Dumb regulations produce the opposite of their intended effects, have all sorts of unintended consequences, or get used for fully intended but pernicious consequences like driving out competition. Smart regulations don't.

The main lesson of the financial crisis is not that we did not have "enough" regulations -- we had hundreds of thousands of pages of regulation. The lesson of the financial crisis is that most of those were "dumb" regulations. Their massive unintended consequences led to a fragile financial structure. Yes, we need financial regulation, but "smarter," not necessarily "more."

This observation is commonplace, but there is a second dimension of regulation on my mind as I think about Dodd-Frank and where we're headed. Let us call it "law, rules, or discretion."

"Regulation" can be enshrined in law. It is a law in the state of Illinois that you can't go over the posted speed limit. The limit may be too high or too low, but you know exactly where it is, and you have clearly defined rights. The cop has to measure a speed and you can defend yourself in court. The law is passed by legislators who must be reelected, so there is a mechanism, albeit imperfect, to fix it.

Often, the details of a regulation are too complex to sensibly be enshrined in law, so Congress delegates rule-writing authority. The FAA writes the regulations governing air safety. Those regulations may be maddening, overly complex, stifling of innovation, but they are at least clear rules: Do x y and z and you get your pilot's license. You can appeal the FAA's decisions by reference to written rules. And there is an open rule-making and fixing mechanism, more effective in this case than acts of Congress.

And then there is discretion. Congress empowers "czars" who can do as they see fit, and tell businesses after the fact how to operate. They issue thousands and thousands of pages of rules, but the rules are often vague, impossible to satisfy, and serve to limitlessly expand rather than limit the discretionary power of the regulator.

This is really the basic problem with the Dodd-Frank approach to financial regulation. The Financial Stability Council can simply "determine" you pose a "systemic risk," and that's it. (Yes, there is an appeal process, but without an objective standard, it's hard to see how anyone will beat a "determination.") The Fed can then tell you how to run your business, in any way that it deems appropriate. Imagine what chaos would result if "speeding" were defined simply by the cop's authority to "determine" that your speed poses a "risk to the traffic system."

We pride ourselves that we are a society based on the rule of law. Well, if not law, at least rules, clearly and publicly written, with limits on government power and right of recourse. We abandoned the model that an unelected aristocracy would direct our affairs as they saw fit.

The aristocratic temptation is understandable. If you can't define "systemic risk" it's tempting to just put a Wise Regulator in charge who will know it when he or she sees it. But we became a society of laws not based on whim or philosophy, but on hard experience with the discretion of even the most benevolent aristocrats. An experience we seem, alas, destined to suffer again.

Krugman on stimulus

2011-12-31T14:57:00.000-06:00

I usually don't respond to Paul Krugman's blog posts. But last week he wrote about Stimulus and Ricardian Equivalence. The post gives a revealing view of his ideas, so it's worth making an exception.

Paul explains:

...think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan .... If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

So, according to Paul, "Ricardian Equivalence," which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong?

How indeed?

The answer is, we didn't, and Paul got this one wrong.

We all agree that "Ricardian Equivalence" is how the economy would and should work, if there were no "frictions," or other problems. Yes, even Paul, who writes

It [Ricardian Equivalence] is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.

Read that carefully for admission of the converse: if the economy is functioning right, if people are not "liquidity constrained," if people are smart enough to recognize that today's deficits mean tomorrow's taxes, then Ricardian equivalence does hold and stimulus doesn't work. (More careful discussion with a few more ifs here, here and here.)

So according to Paul, the prediction of a properly functioning economy is that people who take out a $100,000 mortgage consume $100,000 less in the first year; that they do not do so is proof stimulus works.

But of course it is not! People who take out a $100,000 mortgage with $6,000 payments per year should spend about ... $6,000 per year less on other things. Much of that $6,000 comes out of rent they are no longer paying on the house or apartment they moved out of, so there is not necessarily any change in their consumption of housing services. Some of the $6,000 goes to principal payments, which are a form of saving, allowing the household to put less in the bank. So, in fact they need not change consumption or saving at all!

In fact the classic view predicts exactly what common sense predicts: No, the family does not make radical $100,000 changes in its consumption plans thank you very much.

But what about the extra $100,000 of "spending"? Doesn't the new house contribute to "aggregate demand?" What, in the classic view, goes down by $100,000?

The question is not the family's spending, but where did the $100,000 come from, and what were they going to do with the money?

Most likely, someone was saving money, and put it in a bank. If this family didn't take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house. Or perhaps the money came from an investor in mortgage-backed securities, who would have built a factory instead. These are where the $100,000 offset in aggregate demand comes from, and why the family's decision to take out the mortgage need have no effect on aggregate demand.

Can something go wrong in that process? Sure. That's what real analyses of stimulus think about. But those like myself who, reading theory and evidence, come to the conclusion that stimulus doesn't work well, do not come to that conclusion because we think the family will spend $100,000 less!

To me, this example illustrates beautifully how Krugman "got this wrong." He never asked where the $100,000 loan came from! In his analysis of government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise. People "with an economics training" are supposed to remember lesson one -- follow the money and pay attention to budget constraints. His stimulus is manna from heaven, not borrowed money.

Good advice to anyone: If you get up one morning with the brilliant insight, "Bob Lucas thinks that a family who takes out a $100,000 mortgage will reduce consumption by $100,000," have a cup of coffee, settle down and think, "Wait, Bob's a pretty smart guy. Did I get this wrong somehow?" before hurling insults Bob's way in the New York Times' blog section.

(Note, this is about Krugman's analysis, not stimulus in general. There are plenty of serious analyses of fiscal stimulus that do not make simple logical errors. The plausibility of their assumptions and how they fit the data is an interesting topic. For another day.)

PS: Why is it my new year's resolution not to respond to Krugman blog posts?

Really, what do you do with a guy who insults fellow economists, while admitting in writing that he doesn't even read the opeds and blog posts that are the cause for his insults (let alone their actual academic work, where ideas can be documented and defended)? He often doesn't even link or name the articles he's criticizing so his readers can decide for themselves!

If you don't believe me, look here , here, here, here and... well, I could go on. Just search his column for anyone he disagrees with. (And dear New York Times, is there anyone left in the journalistic ethics or fact-checking department?)

The best answer to that sort of thing is silence. Which I resolve to maintain, along with that diet and hitting the gym....

The Fed's Mission Impossible

2011-12-29T09:23:00.001-06:00

A Wall Street Journal Op-Ed reviewing the latest Fed's proposal (press release) to regulate big banks -- and, soon, everyone else. Here's the much more fun introduction, which we had to cut for space,

Imagine that your brother-in-law and his 5 buddies are heading for LasVegas. Again. You already cosigned the refi on his house, and it was only alast-minute wire to the bail bondsman that got him out of the slammer last time.

So, you’re going to have another little kitchen-table talk about “therules.” This time, no lending to your buddies (“limits on credit exposure”). Nobuying rounds of drinks (“limit dividend payouts and bonuses”).And for God’s sake, don’t lose it all on one silly bet (“stress test”). Keepsome cash for the flight home (“liquidity provisions.”) No pawning the wife’sengagement ring for one last double-or-nothing (“leverage limits”). And if Ihear there’s trouble, I’m going to come out myself and make sure you don’toverdo it. (“Early remediation”)

Sure, he says, with a twinkle in his eye. Because you both know he’sgot your credit card, and you’re not going to let your sister live in poverty(“systemically important”). And you can’t talk about her dumping this lug(“breaking up the big banks”), or at least stopping these Vegas trips (“VolkerRule”), not unless you want to sleep on the couch for a month (“Dodd Frank”).

On to the real oped:

The Fed's Mission Impossible

The Federal Reserve last week announced its new "Enhanced Prudential Standards and Early Remediation Requirements" for big banks, as required by the Dodd-Frank law. You have to pity the poor Fed because it faces an impossible task.

The Fed's proposal opens with an eloquent ode to the evils of too-big-to-fail and moral hazard. And then it spends 168 pages describing exactly how it's going to stop any large financial institution from ever failing again.

More capital is at least a step in the right direction. But the Fed's capital proposals don't go nearly far enough. Putting less than one investor dollar at risk for every 10 borrowed dollars seems laughably low when we're guaranteeing the debts. With a 50-50 chance of a banking tsunami coming across the Atlantic from Europe, you wonder why the Fed is allowing any dividends at all.

But there's nothing here to solve the deeper problems. The last generation of smart MBAs got around capital requirements by pooling risky assets into "AAA" securities that had lower risk weights, and then putting those securities in special-purpose vehicles with off-balance-sheet credit guarantees. Voilà! Same risk, no capital. I can't wait to see what they come up with this time. Diligently following risk weights, European banks built capital ratios by selling good loans and keeping "risk-free" sovereign debt.

The Fed's proposed "credit limits" are a revealing mess. They seem simple and obvious—big banks can't bet more than 10% of their equity on a single counterparty.

But on second thought, it's not so obvious. This wasn't the problem we had in 2008. Banks didn't fail because they lent to other banks. We had a classic run: Investors pulled money from banks that lost a lot on mortgage-backed securities. Yes, banks take too much risk. But they have no incentive to take stupid undiversified counterparty risk.

Credit limits are not so simple either. Suppose you buy a $100 Bank of America bond. OK, you have $100 at risk, though usually there is some recovery in default. But what if they give you $102 of collateral, yet that collateral might be hard to sell or stuck in court for a while? How does a regulator measure that risk? Or what if loans from A to B are funneled through shell company C using derivatives? Ten percent of equity is less than 1% of assets, and a tiny fraction of gross exposures, so measuring it right will matter a lot.
How does the Fed address these problems? Read the 22 pages of overview with 39 separate explicit questions. Translation: Help! We have no idea how to measure and regulate "credit exposure" for modern banks.

The Fed's proposed "triggers" for "early remediation" are interesting attempts to regulate the Fed, not the banks. The Fed recognizes that last time "while supervisors had the discretion to act more quickly, they did not consistently do so." Triggers will force the machinery to action.

Or will they? You're a regulator facing a bank in trouble. If you label it in trouble, you will start a panic in markets. This is the inherent contradiction—your job is to prop up banks, not cause runs. We'll see.
The Fed goes on to a chilling list of "corporate governance" rules, gems such as: "The covered company's board of directors (or the risk committee) must oversee the covered company's liquidity risk management processes . . . [and] determine whether each line or product has created any unanticipated liquidity risk." Well, duh, isn't that what boards do? Why must this be written into federal regulations, with force and penalty of law?

The Fed's proposal exemplifies what a recent editorial in these pages described as Washington's "badly written bad rules." Everything under the sun gets regulated, with no attempt to measure benefits or costs. Sure, as the Fed make clear, Dodd-Frank is to blame, but it could fight back just a bit.

Big picture time. Is any of this going to work?

For 70 years, our government has sought to stop crises by guaranteeing more and more debts, explicitly with deposit insurance, or informally with predictable too-big-to-fail bailouts. Guaranteeing debts gives obvious incentives to gamble at taxpayer expense, so we try to limit risks with regulation. But big banks still have every incentive to avoid, evade and financial-engineer their way around the rules, and they have lots of lawyers, lobbyists and ex-politicians to pressure regulators to use their wide discretion. The government has lost this arms race time and time again. Will this new round of rules, and greater discretionary supervision, finally stop too big to fail?

The depressing scenario is that the six big banks will use this massive regulation as an anticompetitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with continuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965.

The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year's Dodd-Frank financial legislation and the Fed's rules, which allow the government to step in whenever they decide that a financial risk is "systemically important."

What is not "systemically important?" How I can I build a new financial company that demonstrably causes no "systemic" danger—and is therefore not subject to the Fed's onslaught of regulation, discretionary supervision and "remediation"? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized "resolution"?

The Dodd-Frank legislation never defines "systemic" or, more importantly, its absence. Under the law, the Financial Stability Council can just "determine" that any company might have "serious adverse effects on financial stability." They can consider any "factors that the Council deems appropriate." The Fed proposes to subject any company to "other requirements or restrictions" if it thinks existing rules do not "sufficiently mitigate risks to U.S. financial stability."

There is nothing to say that a risk to "financial stability" can't be, for example, taking profits away from the big six, or a failure that takes money away from an influential voting bloc. Don't laugh: Life insurance companies were bailed out in 2009 at least in part so they could keep up payments on guaranteed-return retirement products.

The Fed does not propose any such limit to its powers or describe how it will encourage a financial system free of too-big-to-fail firms. The Fed's report has instead a searching inquiry on how it can expand its powers, and how it can begin "designating" and regulating companies beyond the big banks.

If we are going to get out of the guarantee-regulate-bailout trap, we must legally define what is not too big, and what can, will and must—by absence of legal authority—fail. If the government won't break up too-big-to-fail banks, we must at least allow competition to do it.

Health economics by anecdote

2011-12-26T12:58:00.001-06:00

In a big-think post "Is capitalism sustainable" on Project Syndicate, Ken Rogoff put in this little zinger

A third problem is the provision and distribution of medical care, a market that fails to satisfy several of the basic requirements necessary for the price mechanism to produce economic efficiency, beginning with the difficulty that consumers have in assessing the quality of their treatment.

Ok, a difficulty of the blogging/oped medium is that you have to keep things short, and I too hate to be quoted for little snippets out of context...But, really, Et tu Ken?

It's hard to know if the car mechanic is doing a good job. Get ready for the Federal takeover of the car industry. I can't tell B grade exterior from A grade interior plywood, so we need a Federal takeover of home rehab. Vets and dentists operate outside of the mass of stifling health care and insurance regulation, so I guess they're in for the treatment next.

Is it really that much harder to assess the quality of treatment for all health care than the other services we receive? For all medical care, not just extreme cases? Actually, my doctor complains that everyone who comes in has spent a week on the internet and knows too much about treatment options. The internet is ushering in a grand era of star ratings and consumer information.

Where is the evidence? Just this sort of armchair argument has been used for centuries (remember the guilds?) to justify competition-stifling regulation of all sorts of businesses. Milton Friedman's PhD thesis showed that licensing doctors was good for raising doctor's salaries, but didn't do much for the quality of health care. (His later essay on health economics is still a classic.)

And as always, the real argument for the free market is not that the market is perfect, but that the government is usually far worse. Do we have any evidence that government regulators assess the quality of care better than the people whose lives and money are at stake? Is there any vaguely plausible way that the small asymmetric information in health care justifies the monstrous system we have constructed?

Rant over. But really, there is a lot of harm passing around anecdotes like these as if they are agreed-on economic facts, representing both documentation and a serious cost-benefit tradeoff of viable alternatives.

(I've written a bit more on free-market heath insurance here. )

All the world's troubles in 10 minutes

2011-12-26T11:54:00.000-06:00

Last month, John Taylor asked me to give some lunch-time remarks at a conference on "Restoring Economic Growth" at the Hoover institution. "Oh," said John, "Just talk about what's going on in Europe and how to fix the U.S. economy. Keep it to about 10 minutes." As any economist knows, it's easy to talk for an hour and nearly impossible to talk for 10 minutes. Then I looked at my fellow panelists, who turned out to be George Schultz and Alan Greenspan. Heady company, I feel like a kid again.

The euro crisis,some emerging thoughts on how to create a run-free financial system, a review of why everything on the current policy agenda does not have a prayer of working, and a note of cation to economists' collective habit of jumping from bright idea to policy. (There is a permanent version on my webpage)

In case you’re not reading the papers, we’re in financial crisis 3.0, a run on European banks stemming from their sovereign debt losses.

This is not high finance. European banks have been failing on sovereign debt since Edward III stiffed the Perruzzi in 1353. This is not a “multiple equilibrium,” a run of self-confirming expectations. People are simply getting out of the way of sovereign default, since it’s pretty clear that governments are at the end of the bailout rope.

By dutiful application of bad ideas and wishful thinking, the Europeans have turned a simple sovereign restructuring into a currency crisis, a fiscal crisis, a banking crisis, and now a political crisis. They could have had a lovely currency union without fiscal union. The meter in Paris measures length. The Euro in Frankfurt measures value. And sovereigns default, just like companies. They could do what George Schulz beautifully called the “simple obvious” things, and return to the kind of strong growth that would let them pay off large debts. Alas, the ECB is full in, both buying debt and lending to banks who buy debt, so now a sharp euro inflation – which is just a more damaging and wider sovereign default -- seems like the most likely outcome.

How did we get here? Financial crises are runs. No run, no “crisis.” People just lose money as in the tech bust. (Let me quickly plug here Darrell Duffie’s “Failure Mechanics of Dealer Banks.” This wonderful article explains exactly how our financial crisis was a run in dealer banks.)

For nearly 100 years we have tried to stop runs with government guarantees -- deposit insurance, generous lender of last resort, and bailouts. That stops runs, but leads to huge moral hazard. Giving a banker a bailout guarantee is like giving a teenager keys to the car and a case of whisky. So, we appoint regulators who are supposed to stop the banks from taking risks, in a hopeless arms race against smart MBAs, lawyers and lobbyists who try to get around the regulation, and though we allow – nay, we encourage and subsidize –expansion of run-prone assets.

In Dodd-Frank, the US simply doubled down our bets on this regime. The colossal failure of Europe’s regulators to deal with something so simple and transparent as looming sovereign risk hints how well it will work. (European banks have all along been allowed to hold sovereign debt at face value, with zero capital requirement. It’s perfectly safe, right?)

The guarantee – regulate - bailout regime ends eventually, when the needed bailouts exceed governments’ fiscal resources. That’s where Europe is now. And the US is not immune. Sooner or later markets will question the tens of trillions of our government’s guarantees, on top of already unsustainable deficits.

What financial system will we reconstruct from the ashes? The only possible answer seems to me, to go back to the beginning. We’ll have to reconstruct a financial system purged of run-prone assets, and the pretense that nobody holds risk. Don’t subsidize short-term debt with a tax shield and regulatory preference; tax it; or ban it for anything close to “too big to fail.” Fix the contractual flaws that make shadow-bank liabilities prone to runs.

Here we are in a golden moment, because technology can circumvent the standard objections. It is said that people need liquid assets, and banks must borrow short and lend long to provide such assets. But now, you could pay for coffee with an electronic transfer of mutual fund shares. The fund could hold stocks, or mortgage backed securities. Nobody ever ran on a (floating-NAV) mutual fund. With instant communication, liquidity need no longer coincide with fixed value and first-come first-serve guarantees. We also now have interest-paying reserves. The government can supply as many liquid assets as anyone wants with no inflation. We can live the Friedman rule.

Short-term debt is the key to government crises as well. Greece is not in trouble because it can’t borrow one year’s deficits. It’s in trouble because it can’t roll over existing debt. Governments can be financed by coupon-only bonds with no principal repayment, thereby eliminating rollover risk and crises. The new European treaty, along with wishing governments would mend their spending ways, should at least insist on long-maturity debt.

You may say this is radical. But the guarantee – regulate – bailout regime will soon be gone. There really is no choice. The only reason to keep the old regime is to keep the subsidies and bailouts coming. Which of course is what the banks want.

On to the US: Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense:The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment – of anything but tax lawyers and lobbyists -- because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because 1.5 trillion of excess reserves aren’t enough to mediate transactions?

I posed this question to a somewhat dovish Federal Reserve Bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had four humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors are debating whether to give him a double espresso or a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937 – not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so, the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

People hate this answer. They want to know “what would you do?” What’s the bold new plan? What’s the big new idea? Where is the new Keynes? They want FDR, jutting his chin out, leading us from the fear of fear itself. Alas, the microeconomy is a garden, not an army. It grows with property rights, rule of law, simple and non-distorting taxes, transparent rules-based regulations, a functional education system; all of George’s “simple obvious steps,” not the Big Plan for the political campaign of a Great Leader.

You need to weed a garden, not just pour on the latest fertilizer. Our garden is full of weeds. Yes, it was full of weeds before, but at least we know that pulling the weeds helps.

Or maybe not. This conference, and our fellow economists, are chock full of brilliant new ideas both macro and micro. But how do we apply new ideas? Here I think we economists are often a bit arrogant. The step from “wow my last paper is cool” to “the government should spend a trillion dollars on my idea” seems to take about 15 minutes. 10 in Cambridge.

Compare the scientific evidence on fiscal stimulus to that on global warming . Even if you’re a skeptic, compared to global warming, our evidence for stimulus -- including coherent theory and decisive empirical work -- is on the level of “hey, it’s pretty hot outside.” And compared to mortgage modification plans, strange “unconventional” monetary policy, the latest creative fix-the-banks plan, and huge labor market interventions, even stimulus is well-documented.

There are new ideas and great new ideas. But there are also bad new ideas, lots of warmed over bad old ideas, and good ideas that happen to be wrong. We don’t know which is which. If we apply anything like the standards we would demand of anyone else’s trillion-dollar government policy to our new ideas, the result for policy, now, must again be, stick with what works and the stuff we know is broken and get out of the way.

But keep working on those new ideas!

How to destroy the middle class

2011-12-25T18:30:00.000-06:00

In a splendid recent editorial piece, The New York Times distilled every bad idea floating around the liberal policy agenda.

A few choice moments:

"Economic growth alone, ... would not be enough to restore the middle class"..."To lift wages requires generous tax credits for low earners, a higher minimum wage, and guaranteed health care" ... "Job training efforts"

That is, after all, how our ancestors got off the farm.

"...the [jobs] bill recently filibustered by Republicans would have created an estimated 1.9 million jobs in 2012."

I didn't know the tooth fairy was making economic "estimates" these days.

..."unrelenting political pressure for principal write-downs of underwater loans, expanded refinancings for borrowers in high-rate loans, and forbearance for unemployed homeowners."

Econ 101 quiz. What happens to the unemployment rate if you don't have to pay your mortgage so long as you don't get a job?

"..all forms of income to be taxed at the same rates"

That means dividends and capital gains at the 39.5% rate. Well, at least it's consistent. If you don't believe in saving and investment, taxing the heck out of them should do the trick.

"a financial transactions tax."..."high-end tax increases.. to control the deficit".... "public education, Social Security, unions, child care, affirmative action and, not least, campaign finance reform"

Read on, (how to destroy the) "Middle Class Agenda" at the New York Times

A continent of bad ideas

2011-12-25T16:20:00.000-06:00

Why does noone see that Europe can have a nice currency union without fiscal union? I tried to put together this and some of the other bad ideas that I think are clouding the euro crisis debate in this post on the IGM/Bloomberg "business class" blog.

By artful application of bad ideas, Europe has taken a plain-vanilla sovereign restructuring and turned it into a banking crisis, a currency crisis, a fiscal crisis, and now a political crisis..

Read more here