## Friday, April 12, 2019

### Perpetually wrong forecasts

Torsten Slok of Deutsche Bank sends along the following fascinating graphs

The titles seem a little off. Yes, the market is expecting rate cuts (forward rate) but the market has been exactly wrong about everything for 10 years (and longer) first forecasting the recovery that never came, then forecasting much slower interest rate rises than actually happened.  Survey expectations seem to match the forward curves well except perhaps at the very end.

Mechanically, a rising forward curve and rates that never rise means you earn a lot of money in long term bonds. It's a "risk premium" Monika Piazzesi and Eric Swanson point out this pattern is common. The same pattern holds in longer term bonds, as well known since Fama and Bliss. An upward sloping term structure indicates higher expected returns on long term bonds, and vice versa. And it makes some sense. In recessions, people don't want to hold risks, so we expect a premium for riskier assets. In booms, as interest rates rise, people are more willing to take risks.

Still it's unsettling for lots of reasons. Why did the forward curve suddenly flatten exactly when interest rates finally took off? Another interpretation is something like a Poisson process in the end of recessions, in which the chance of fast recovery is independent of how long you've been in a recession, rather than arriving slowly and predictably. That makes it rational to continue these expectations persist despite continual disappointment, and to change forecast quickly once the long-awaited fast growth arrives.

## Monday, April 8, 2019

### Meer On Minimum Wage

David Henderson posts a thoughtful draft op-ed by Jonathan Meer on minimum wages. Two talents of  great economists are to recognize that averages hide big differences among people, and to imagine all the avenues of substitution and unintended effects of a regulation. The oped excels:

Substitution:
when the minimum wage is raised, employers offset increased labor costs by reducing benefits like the generosity of health insurance. Other benefits, like free parking or flexibility in scheduling, are more difficult to measure but are also likely to be cut back. Employers will likely expect more work effort when they are forced to pay more, changing the nature of jobs. And in the longer run, economists have found that employers shift towards automation and expecting customers to do more things themselves– reducing job growth in ways that aren’t always obvious. This damage takes time to be seen, which is one reason minimum wage hikes, like rent control, often seem appealing.
Who gets jobs?
When debate focuses on the total number of jobs lost or gained, it hides this potentially nasty distribution of the benefits: a recent college graduate with a barista job may get a few more dollars an hour, but the high school dropout finds it harder to get and keep a job. ...
The teenage children of well-off families, earning money to buy video games, are treated the same as single moms struggling to get by. When wages are set at an artificially high rate, why should an employer take a risk on the single mother who needs the occasional shift off to take her kids to the doctor? The kid from a disadvantaged background who needs some direction on how to treat customers appropriately? Or the recently released felon trying to work his way back into the community? Why should employers bother with them when there are plenty of lower-risk people who are willing to work at those artificially high wages?
It will get much worse in the next recession...Those at the margins of the workforce will be left further behind. Low-wage jobs aren’t easy, don’t pay well, and are rarely fun. But not being able to find work at all is far worse.
Despite the lowest unemployment rates in decades, only 39% of adults without a high school degree had a full-time job in 2018 – and among young African-Americans dropouts, it’s a shocking 26%. It’s hard to believe that the best way to help them find work and start climbing the job ladder is to put the first rung out of reach, making it difficult for them to find work and driving them to illegal employment with few protections.
We should never minimize the struggles of low-income families to get ahead. But good intentions are no substitute for good policy. Minimum wage proponents mean well, but the unintended consequences hurt the worst-off the most.
Jonathan isn't just making this up as us bloggers tend to do. He points to "The Minimum Wage, Fringe Benefits, and Worker Welfare, with Jeffrey Clemens and Lisa B. Kahn
...state-level minimum wage changes decreased the likelihood that individuals report having employer-sponsored health insurance. Effects are largest among workers in very low-paying occupations,
and Dropouts Need Not Apply: The Minimum Wage and Skill Upgrading
workers employed in low-paying jobs are older and less likely to be high school dropouts following a minimum wage hike.... job ads in low-wage occupations are more likely to require a high school diploma following a minimum wage hike,
Related, Zachary S. Fone, Joseph J. Sabia, Resul Cesur find exactly the predicted substitution into criminal activity
find that raising the minimum wage increases property crime arrests among those ages 16-to-24, with an estimated elasticity of 0.2. This result is strongest in counties with over 100,000 residents and persists when we use longitudinal data to isolate workers for whom minimum wages bind. Our estimates suggest that a $15 Federal minimum wage could generate criminal externality costs of nearly$2.4 billion.
Hat tip to David Henderson, who posted the draft oped and a link to the excellent Jonathan Meer - James Galbraith debate, and to the indefatigable Marginal Revolution. I saw an early draft of the oped, and hoped Meer would be able to publish it, at least somewhere like WSJ. It's not too late!

Update:

Jonathan passed on this tidbit from Obenauer & von der Nienburg, “Effect of Minimum-Wage Determinations in Oregon,” July 1915, yes 1915
“The belief was very prevalent among store women that the minimum wage had wrought only harm to them as a whole. The experienced women contended that formerly they had gotten through the day without any hurry or strain. If it was necessary to work a few minutes overtime, they did so willingly. Now, they said, they are under constant pressure from their supervisors to work harder; they are told the sales of their departments must increase to make up for the extra amount the firm must pay in wages.”
Plus ça change...

Overall, it's a shame that economists have bought the popular discourse that all that matters are "jobs," as if it were 1933, not the vast range of the terms of employment -- how hard you have to work, hours, tasks, flexibility, side benefits, overtime, and so forth.

## Friday, March 29, 2019

### Operating Procedures

The Fed sets interests rates. But how does the Fed set interest rates? The Fed is undergoing a big review of this question. We had a little workshop at Hoover, in preparation for the larger May 3 Strategies for Monetary Policy conference, which provokes the following thoughts.

Issue

Here is the issue.

The graph plots the demand for reserves, as a function of the interest rate on other short-term assets such as overnight federal funds, Libor, money market rates, and so on.

(Reserves are accounts that banks have at the Fed. The Fed sets the interest rates on such accounts.)

The lower horizontal line is the rate the Fed pays on reserves.

If the interest rate on other similar assets (overnight federal funds, Libor, repo rates) is above the interest rate on reserves, then banks should want to get rid of reserves. However, reserves are useful, as money is useful, so banks are willing to hold some even when they lose interest on reserves by doing so. The greater the interest costs -- the greater the difference between the rate banks can lend at and the rate they get on reserves -- the more they work hard to avoid holding reserves. At the end, there are legal and regulatory requirements to hold reserves.

In the flat zone, banks are satiated in reserves. Reserves don't have any marginal liquidity value. But banks are happy to hold arbitrary quantities as an asset so long as the interest on reserves is above or equal to what they can get elsewhere.

If banks can borrow at less than the interest on reserves, they would do so and demand infinite amounts. Therefore, competition among banks should drive those rates up to the interest on reserves.  Similarly, if rates banks can lend at are higher than interest on reserves then banks should compete to lend, driving other rates down to the interest on reserves. Therefore, the Fed by setting the interest on reserves sets the overall level of overnight interest rates.

Questions

Here are the questions:

1) Where should the supply of reserves be? This is the biggest question the Fed is asking right now. The three vertical lines in the graph are three possibilities.

The Fed currently fixes the supply of reserves, which is referred to as the "size of the balance sheet," so the lines are vertical. The Fed raises the supply of reserves by buying assets such as treasuries or other assets, "printing money," i.e. creating reserves, in return for the assets. The balance sheet shows the assets (e.g. Treasuries) against liabilities (reserves and cash). Yes, the Fed is nothing more than an enormous money market fund, offering fixed value floating rate accounts which it backs by treasury and other securities.

The debated is couched as "floor system" vs. "corridor system."  A "floor system" refers to the two supplies on the right, where there are so many reserves that the other interest rates will equal the rate on reserves.

There are two floor-system variants: abundant reserves, with the supply well to the right, and minimalist reserves, with the supply of reserves set to the smallest possible level, where the demand curve just hits the lower bound, "satiation" in reserves. The latter seems to be where the Fed is heading -- a minimal-reserves floor system.

In a "corridor system," the Fed has an upper and lower band for the market interest rates it wants to target. Historically this was the Federal funds rate, which is the rate at which banks lend reserves to each other overnight. It tries to place that interest in the middle of the band, by artfully putting the supply of reserves in the downward sloping component. This is how the Fed operated before 2008.

The rate at which the Fed is willing to lend reserves also provides an upper bound, which I'll get to in a minute.

2) If there is going to be a corridor, which rate should the Fed care about? The (justly) moribund federal funds rate? The overnight general collateral repo rate? Libor? One advantage of the abundant floor, is that the Fed can stay quiet about all this and let the market sort out just what kind of overnight lending it prefers.

3) If there is a band, how wide should the range between the upper and lower bound be?  1%? 0.5? 0.25%? 0.01%?

3) How free should lending and borrowing be? Who gets access to interest paying reserves, and how much interest do they get? Who can borrow reserves, and on what therms -- what collateral is acceptable, is it overnight or term borrowing, does such borrowing incur formal regulatory attention or informal "stigma"?

4) What assets should the Fed buy on the other side of the balance sheet, or accept as collateral if it lends reserves?  Just short-term treasuries? (My favorite) The current mix of long term treasuries and mortgage-backed securities? Or, perhaps, follow the ECB and BOJ and buy corporate bonds and stocks, many countries debts, or lend newly created reserves to banks and count the loans as assets?

The motivations here are, I think, as much political as economic, and it's better to acknowledge that. (We should understand the Fed can't do that in writing, but we can!) Having touted QE as extraordinary accommodation the Fed is under big pressure to stop stimulating. It's too late to say that QE was mostly symbolic. Having seen the Fed buy all sorts of securities, congresspeople are coming up with dandy ideas for new things the Fed can "invest" in by printing money. Having paid banks about a quarter point more than they can get anywhere else, and indeed allowed a pleasant little arbitrage to go on, the Fed is under pressure to pay other investors the same. Congress is even more full of ideas for who the Fed should lend to, and how the Fed should use its expanded regulatory powers to channel credit here and deny credit there.

"Normalization" is a pretty meaningless economic term to me -- why is whatever the Fed was doing in 2007 "normal," why is it good? But "normalization" is a tremendously useful marketing banner. We're going back to "normal," so leave us alone with your bright ideas. Well, fine, but let us quietly  go to a new normal that incorporates all the interesting things we've learned in the last 10 years.

I like the "floor" system, with abundant reserves. The great lesson of the last 10 years is, we can live the Friedman rule. We can have money that pays full interest, so that holding money has no opportunity cost, and this will not cause inflation. This is genuinely new knowledge. Liquidity is free! There is no need for people to waste time and effort on cash management. Liquidity is good for financial stability too: Banks holding huge reserves don't fail.

I go beyond the abundant floor: The Fed should not target the supply of reserves at all. The supply curve of reserves should be horizontal.  The Fed should just say, "bring us your treasuries, and we'll give you reserves and pay the IOER rate." Or, "Bring us your reserves and you can have treasuries."

Why? Well, if you want to target a price, you offer to buy and sell freely at that price. If you want to target an interest rate, target an interest rate. We have seen limited arbitrage between reserves and other assets due to lack of competition in banking and Fed restrictions, who can hold reserves, and the fixed supply.

I see no economic or financial harm whatever from arbitrary expansion of the Fed's balance sheet, if the assets are all short-term Treasuries. Reserves are just overnight, electronically transferable government debt. If the banking system wants more overnight debt and less three week to six month debt, let them have what they want. I see no reason to artificially starve the economy of overnight debt.  The Fed offers free exchange between cash and reserves; the government as a whole should offer free exchange between short term treasuries and overnight treasuries, i.e., reserves.

To accommodate the economy's desire for ample reserves, and the Fed's desire not to provide them, the Treasury should offer the same asset, and the Fed should encourage this and work with the Treasury to make it happen.

Specifically, the treasury should issue overnight, fixed-value ($1), floating-rate, electronically-transferable debt. Let's call it treasury electronic money. Legally, this is treasury debt that any individual or financial institution can hold, just as they can hold treasury bills or treasury coins. Functionally, these are interest-paying reserves. Like reserves, but not even like T bills, these can be bought or sold immediately: Owners can transfer their ownership of$1 worth of treasury money to someone else on the treasury website, and owners can sell $1 worth of treasury money and have the money wired (i.e. the treasury sends$1 of reserves to the owner's bank) instantly. (Details here.)

Given the Fed's resistance to narrow banking, and the potential of treasury electronic money to undercut bank's (subsidized) deposit financing, I suspect the Fed's first instinct would be to fight such an innovation. The Fed should overcome that instinct and welcome a solution to the problem of providing lots of liquid assets without the (genuine, below) downsides the Fed feels about a large balance sheet.

I agree with critics that the composition of the Fed's assets should return quickly to short-term treasuries only, and in my ideal world to just this treasury electronic money. That is mostly for political economy reasons outlined below. Other assets should be on the balance sheet in emergencies only.

If the Fed feels the need to buy long-term treasurys or take them as collateral, issuing reserves in return, because of a shortage of safe assets, that means the Treasury has not issued enough short-term liquid treasurys. There are simpler ways to fix that problem.

## Tuesday, March 26, 2019

### Central Bank Independence

I'm on a panel at the "ECB and its watchers" conference Wednesday, to discuss central bank independence. Here are my comments. Yes, there is a lot more to say, but I get exactly 15 minutes. I hope I'm not scurrying back tomorrow to retract something stupid here.

Central Bank Independence
John H. Cochrane
Hoover Institution, Stanford University
Remarks presented at the “ECB And its Watchers” conference, March 27 2019.

I believe central bank independence is a good thing, and that it is in increasing danger. I don’t think that’s a controversial view, or we would not be here.

I sense that our mission today is to decry politicians that wish to influence the central banks’ good works, especially by pressing for low interest rates.

But I’ll argue instead that much of the threat to central bank independence stems ultimately from how central banks are behaving, and has little to do with interest rates.

Principles

What is, can and should be independent? Let me suggest three principles.

1) In a democracy, independence must come with limited powers, and a limited scope of authority.

2) An independent agency must follow rules, norms, and traditions, not act arbitrarily, with lots of discretion.

3) To be independent, an agency must be, and be perceived to be, competent at its task.

What cannot be independent? A lot of government activity transfers wealth from one person to another, or fights for political power. Those activities must be politically accountable.

Limited powers: Central banks operate within legal restrictions. For example, it seems puzzling that central banks struggle to raise inflation. We all know how to stoke inflation: drop money from helicopters. To stop inflation, soak up the money supply with heavy taxes.

Yet central banks are legally prohibited from this one, most effective action for stoking or stopping inflation.  Why? Well, in a democracy, writing checks to voters or confiscating their hard-earned cash must be reserved for politically accountable institutions.

Rules and norms: Most restraints on central bank actions are rules, norms, and traditions, not legal limitations. Central banking remains something of a black art, so central bankers must sometimes use judgement and discretion, especially in crises, and let the rules or norms evolve with experience. But if they are to stay independent, they must quickly return to or re-form rule, norm, or traditional limitations on their power.

From this perspective, the ECB was set up as an almost perfect central bank. It followed an inflation target. It only acted on the short-term interest rate. Its assets were uncontroversial.  And it was not to finance deficits or bail out sovereigns.

The inflation target and Taylor rule are most important here for their implied list of things that the central bank should not, is not expected to, and pre-ccommits not to pay attention to or control directly: stock prices, housing prices, sectoral and industry health, regional imbalances (especially in Europe), credit for small businesses, income and wealth inequality, infrastructure investment, decarbonization, bad schools, and so on.

An independent central bank should say often, “that’s a terrible problem, but it’s not our job to fix it.” It loses power and prestige in the moment, but gains independence in the long run.

Actions:

So what are central banks doing to invite challenges to their independence?

Interest rates get a lot of attention, but they are not, I think, the core of the problem. Yes, President Trump is violating established norms by complaining publicly about interest rates. But most people in both parties understand this is a violation, and a norm worth keeping, so for the moment I think the norm against interest-rate jawboning will hold in the future.

The big threat to independence comes from the expansion of activities and responsibilities that central banks have taken on, on an apparently permanent basis, in the years since the financial crisis: Asset purchases, regulatory expansion, a much larger set of goals, and a marriage of regulatory and macroeconomic policy.

Purchasing assets in dysfunctional markets, as in 2008, is what central banks traditionally do in a crisis. (We can argue whether they should, but that’s for another day.) But once markets returned to normal, continuing to buy large portfolios of long-term bonds, mortgage backed securities, corporate bonds, imperiled European sovereign debt, and even stocks, for years on end, was a different choice.

We can argue the benefits. Maybe QE lowered some rates, a bit, for a while, and maybe that stimulated a bit.

But we have ignored the costs. Central banks took on a new, and apparently permanent power, formerly foresworn: to buy assets directly, to control asset prices, not just short term interest rates.

It is harder to say to a politician, who complains that mortgage rates are too high, that this is not our problem; we set the short term rate to stabilize inflation; we don’t pay direct attention to other assets, or to directing credit to mortgages rather than big business.

It will get worse. The US Congress has noticed the Fed’s balance sheet. Under the mantra of “modern monetary theory,” a swath of congresspeople want the Fed to print trillions of dollars to finance the Green New Deal.

The ECB and euro were set up with a clear rule that the ECB does not bail out sovereigns. In the crisis, President Draghi rather brilliantly stemmed the first debt crisis with a “do what it takes” promise, that did not have to be executed, along with a warning that this could not be permanent.

But in response, Italy took the St. Augustinian approach — Lord, give me structural reform, but not quite yet. The ECB continues to repo government debt and Italian banks are still stuffed with Italian government bonds. The doom loop looms still, and markets still expect a bailout.

The ECB has lost the long run game of chicken. It will likely have to actually do what it takes when the next crisis comes.

But there is little that is more political, little that cannot stay independent more clearly, than bailing out insolvent sovereigns, with euros that must either inflate or be backed up by taxes on the rest of Europe.

The ECB is still directly financing questionable banks and questionable corporations. These are also activities that will invite political scrutiny.

The crisis spawned a vast expansion of regulation. The US Fed is now using an immense,confusing, and constantly changing set of rules to act with great discretion on telling banks what to do.

Moreover such regulation changed from “micro,” somewhat rules-based regulation, to more nebulous and discretionary “macro prudential” regulation that directs the activities of “systemic” institutions — something nobody can define other than “we know it when we see it.” The Fed wanted to include large insurance companies, until courts struck that down, and tried for a while to systemically regulate equity asset managers, on the theory that the managers might sell in a behavioral herd and send prices down.

But telling banks and other institutions what to do, who to lend to, when to buy and sell assets, with billions on the line, using a high degree of judgment and discretion, is a political act that invites loss of independence. Your “bubble” is my “boom,” your “fire sale” my “buying opportunity.”

More than current actions, the ideas swirling around central banks seem to me even more dangerous for their future independence.

It is taken for granted that central banks should embrace the task of managing and directing the entire financial system. This only starts with managing bank assets to try to manage “systemic” risks. It goes on to managing asset prices and housing prices, I guess so that nobody ever loses money again, and directing the “credit cycle.” And central banks should go beyond short rates and asset purchases, and use regulatory tools to direct the macroeconomy and asset markets.

Nobody even seems to stop and think that such actions are intensely political, and will invite strong attacks on central bank independence.

Moreover, faith that we economists and the central banks we populate have any actual technical competence to implement such grandiose schemes is evaporating, and rightly so. That the already vast regulatory system failed to stop the last crisis eroded a lot of trust. In many ways the revelation that elites didn’t know what they were doing led to today’s populism. That once this horse was out of the barn, Europe’s regulators nonetheless kept sovereign debt risk free, inviting a second sovereign debt crisis, eroded more trust. If the next crisis blindsides larger, and much more pretentious grand plans, that trust and the independence it grants will vanish.

Even monetary policy is becoming more dangerous to independence. Much of the post-crisis analysis hinges on how monetary policy effects income transfers, for example from investors to mortgage borrowers or from all of us to bank balance sheets. Well, if the point of monetary policy is to take money from Peter, and give it to Paul, on the grounds that Paul has a higher marginal propensity to consume, Peter is going to call his congressman.

I sense that a lot of this expansion of tools, scope, and discretion comes from a natural human and institutional tendency towards aggrandizement.  It’s fun to become the grand macro-financial planner, always in the news. It’s boring to be a limited, technical institution that says “not my job.”

For example, I think a lot of QE was simply done to be seen to be “doing something” in the face of slow supply-side growth. Remember, monetary problems, especially any ill effects of 1% rather than 2% inflation, do not last 10 years. Long run growth comes from productivity, and structural reform, not stimulus, and not money.

But in the language of central bankers, “growth” and “demand” seem to be synonyms. This morning, describing a decline in growth with no decline in consumption, President Draghi used the word “demand” many times, and “supply” never. Like helicopter parents, central banks want always to be in charge.

Maybe you disagree, but think of the costs. For sure, the promise of endless QE, and reiterating the promise that central-bank provided demand stimulus is the vital answer, lessened the pressure for structural reform.

More generally, imagine that about 5 years ago, central banks had said, “We’ve done our job. The crisis is over. ‘Demand’ is no longer the problem. If you think growth is too low, get on with structural reform. Low inflation and interest rates are fine. Welcome to the Friedman rule. QE is over, and we are no longer intervening in asset markets. In place of intrusive bank regulation, countercyclical buffers, stress tests, and asset price management, we are going to insist on lots and lots of capital so there can’t be crises in the first place. We’ll be taking a long vacation.”

Just how much worse would the overall economy be? We can argue. How much better would the threats to central bank independence be? A lot.

Well, it’s not too late.

Suggestions

Let me offer some practical suggestions:

1) Separate monetary policy and regulation. Regulation is much more intrusive, and much harder to resist political pressure. Using regulatory tools for macroeconomic direction is inherently going to threaten independence. The ECB’s Chinese wall between regulation and monetary policy is a good start.

2) Transfer, or swap, all balance sheet assets other than short term treasuries to a “bad bank,” controlled by fiscal authorities.

3) Solve the sovereign debt problem. Stop the doom loop: get own country sovereign debt out of banks, or backed by capital. Create a mutual fund with a diversified portfolio of government debts, and force banks to hold that if they don't want big risk weights. Allow pan-europeans banks that hold diversified portfolios. Then insolvent sovereigns can default without shooting their hostage.

4) Abandon the pretense that risk regulation, asset price management, and credit allocation policy will stop another crisis. Move to narrow deposit taking and equity financed banking, or at least allow these to emerge rather than fighting them tooth and nail.

The US Fed is clearly perceived to be defending monopoly profits of large banks, a big threat to its independence. If you don’t like President Trump’s tweets, wait for President Elizabeth Warren’s. And she knows where the regulatory bodies are buried.

5) Europe needs structural financial reform more than continued bank support from the ECB. For example, corporate bonds should be held in mutual funds marketed directly to investors.

6) Be quiet. Federal Reserve officials should not give speeches about inequality or other hot-button partisan political issues, no matter how passionately they feel about them.

7) But don’t throw away the bad with the good. In the face of political criticism, I sense central banks, rushing to apply the label “normalization.” The Fed is rushing to reduce the quantity of reserves and go back to older reserve management schemes, losing the lessons of how well an abundant reserves system can work.

Independence is not ours to claim. Central banks are government agencies, not private institutions with rights. Governments grant them independence when it is useful for government to pre-commit not to use some of its vast powers for political ends. Independence must be earned by, well, not using power in ways that must be politically accountable.

Central banks need to answer, What economic problems, are not your job to worry about? What tools will you not use? Central banks need to choose the power and allure of trying to fix everything, and thus acting politically, vs. the limitations that allow independence. They can’t have both. And we voters need to tell our politicians which kind of central bank we want. We can’t have both either.

Having laid out the options, it seems clear to me that nobody wants a limited, and hence independent central bank. The trend to central banks as the large, integrated, monetary-financial-and macroeconomic planners, integrating broad control of financial markets and their participants, is desired by central banks, politicians, and not contested by voters. So they shall be, but not independent.

## Friday, March 22, 2019

### Concentration increasing?

Is the US economy getting more concentrated or less? At the aggregate level, more. This is a widely noted fact, leading quickly to calls for more active government moves to break up big companies.

But at the local level, no. Diverging Trends in National and Local Concentration by  Esteban Rossi-Hansberg, Pierre-Daniel Sarte, and Nicholas Trachter documents the trend.

They make a concentration measure that is basically the sum of squared market shares, so up means more concentrated and down means less concentrated. This is the average of many different industries and markets.

The average concentration of national markets has gone up. But the concentration of smaller and smaller markets has gone down. More businesses are dividing up county and zip code markets.
Industries differ. This graph does not get a prize for ease of distinguishing the lines, but the two red lines just below zero are manufacturing and wholesale trade, where the industries with really dramatic reductions in local concentration are retail trade, finance insurance and real estate, and services.

What's going on? The natural implication is that the town once had 3 local restaurants, two local banks, and 3 stores. Now it has a McDonalds, a Burger King, a Denny's and an Applebees; a branch of Chase, B of A, and Wells Fargo, and a Walmart, Target, Best Buy, and Costco. National brands replace local stores, increasing the number of local stores.

However, that turns out not to be so obvious.

This graph shows what happens in the diverging industries (those in which national goes up, and local goes down) if you leave out the biggest company. Doing so, lowers the rise of national concentration, because we left out the single most concentrated firm. The lower line however, shows a positive effect. If we leave out the largest national firm, the local markets look more concentrated. If  national brands had just replaced local businesses, then when we leave them out, we should see lots of smaller shares.  The same thing happens if we leave out the second and third largest.

What's going on? Well, they look at what happens when Wal-Mart comes to town.

The lower line is the effect on concentration in the years before and after the top national firm enters a market. Concentration drops. If, when Wal-Mart came to town, all the exiting firms went under, concentration would rise. The upper line shows you concentration ignoring the largest enterprise. It's unchanged. Either the mom and pop stores do, in fact, stay in business; or new smaller firms enter along with Wal-Mart. The phenomenon is not just the replacement of all smaller businesses by a larger number of national chains.

The paper was presented at the San Francisco Fed "Macroeconomics and Monetary Policy" conference, where I am today. The discussions, by Huiyu Li and François Gourio, were excellent. As with all micro data there is a lot to quibble with. Is a zip code really a market? Much of the data are industry+zip codes with a single firm, both before and (slightly less often) after. Maybe Walmart and other stores drag in customers from other places? And of course, concentration is not the same thing as competition. The SF Fed will, in a week or so, post the conference, papers, and discussions.

## Wednesday, March 20, 2019

### Less listing

Torsten Slok at DB sent along this lovely graph. The underlying paper "Eclipse of the Public Corporation or Eclipse of the Public Markets?" by  Craig Doidge, Kathleen M. Kahle, G. Andrew Karolyi, and René M. Stulz,  has a lot more.

Stocks are fleeing the exchanges in the US. Small and young stocks are disappearing most, with older larger stocks dominating. Less public means more private, not less companies. Companies are more and more financed by private equity, groups of large investors, debt, venture capital and so forth.

This is largely a US phenomenon, which is important for us to figure out what's going on:

What's going on? Doidge,  Kahle, Karolyi, and Stulz have some intriguing hypotheses. US business is more and more invested in intellectual capital rather than physical capital -- software, organizational improvements, know-how, not blast furnaces. These, they speculate, are less well financed by issuing shares on the open market, and better by private owners and debt.

This shift from physical investment to R&D -- investment in intellectual capital -- is an important story for many changes in the US economy.

Improvements in financial technology such as derivatives allow companies to offload risks without the "agency costs" of equity, and then keep a narrower group of equity investors and more debt financing.
"We argue that the importance of intangible investment has grown but that public markets are not well-suited for young, R&D-intensive companies. Since there is abundant capital available to such firms without going public, they have little incentive to do so until they reach the point in their lifecycle where they focus more on payouts than on raising capital."

I.e. the only reason to go public is for the founders to cash out, and to offer a basically bond-like security for investors. But not to raise capital.

They leave out the obvious question -- to what extent is this driven by regulation? Sarbanes Oxley, SEC, and other regulations and political interference make being a public company in the US a more and more costly, and dangerous, proposition.  This helps to answer the question, why in the US.

The move of young, entrepreneurial companies who need financing to grow to private markets, limited to small numbers of qualified investors, has all sorts of downsides. If you worry about inequality, regulations that only rich people may invest in non-traded stocks should look scandalous, however cloaked in consumer protection. But if you can only have 500 investors, they will have to be wealthy. Moving financing from equity to debt and derivatives does not look great from a financial stability point of view.

Our financial system has become remarkably democratized in recent years. Once upon a time only wealthy individuals held stocks, and had access to the superior investment returns they provide. Now index funds, 4501(k) plans are open to everyone, and their pension funds. What will they invest in as listed equity disappears?

A wealth tax, easy to assess on publicly traded stock and much harder to assess on private companies with complex share structures -- especially structures designed to avoid the tax -- will only exacerbate the problem. More moves to regulate the boards and activities of public companies will only exacerbate the problem.

## Monday, March 18, 2019

### Monopoly in history

Timothy Taylor, the Conversable Economist, tracks down the oft-told story of William Lee and his knitting machine.
...the 2019 World Development Report from the World Bank has a mention near the start of Chapter 1: "In 1589, Queen Elizabeth I of England was alarmed when clergyman William Lee applied for a royal patent for a knitting machine: Consider thou what the invention would do to my poor subjects,' she pointed out. It would assuredly bring them to ruin by depriving them of employment.'”
It's really a lovely story, presaging this fallacy passed down through the ages, to Milton Friedman's famous "let them use spoons" story (on being told a Chinese dam was being made by hand and shovel rather than bulldozers to provide employment) to the current hullabaloo that AI will take all the jobs. (And today. On a KQED (NPR) "forum," show last week, on while I was shaving, a caller expressed just how great it is that Mexico uses people not machines to sweep streets, thereby providing employment, and we should do the same. Fallacies live a long time.)

Lovely as it is, Taylor is "inherently dubious about direct quotations from conversations held in 1589," took a  "journey through libraries and archives," to track down the actual story.  It is an interesting note on the very beginnings of the industrial revolution.

As I read Taylor, it seems the story is actually pretty suspect.
"The underlying source seems to be in an 1831 book, History of the Framework Knitters, written by Gravenor Henson....Henson was an important British trade union leader in the early 19th century. As Stanley D. Chapman notes in his "Introduction" about Henson's purpose in writing the book: "His main theme was that hosiery, lace and all other industries should be regulated by the government so as to maintain a decent living standard for the workers and fair conditions of trade. British industries must be protected from direct foreign competition and, more particularly, from industrial espionage, migration of skilled workmen to other countries, and export of machinery."
So, as I gather indirectly, the story passed on from a source was definitely trying to make a point, and (again reading only Tim) has precious little primary evidence for the famous conversation.

The first lesson: beware these apocryphal stories passed on through secondary, tertiary and ultimately gossipy sources.

This lesson was brought home to me by Peter Garber's great "Famous First Bubbles" book (I had a lot of fun reviewing it). Garber went back to look at actual primary sources behind stories that though apocryphal are passed around as true among economists, such as the famous tulip "bubble." They aren't true either. Though they make good stories.

I got a deeper lesson, on just how economies worked in early modern Europe. Early economies were so pervasively regulated, that the only thing to do with an innovation was to run to get a Royal monopoly.

William Lee invented a stocking-making machine. (Apparently, to put out of employment a woman who spurned his advances while knitting stockings.) So, what does he do with his newfound knowledge?
Having now discovered the method of knitting by machinery, his next effort was directed to obtain the golden harvest which had flattered his imagination. He removed his invention to London for the purpose presenting it to the Queen,...Lee now imagined himself certain of a handsome remuneration,...[but]  she refused to make either a grant of money or secure him a monopoly or patent.
Here is where the famous quote enters
Her answer is said to have been to the following purport: -- My Lord, I have too much love to my poor people, who obtain their bread by the employment of knitting, to give my money to forward an invention which will tend to their ruin, by depriving them of employment, and thus make them beggars.
It goes on, interestingly. The Queen was interested in cheaper silk stockings, which she wore:
Had Mr. Lee made a machine that would have made silk stockings, I should, I think, have been somewhat justified in granting him a patent for that monopoly, which would have affected only a small number of my subjects. but to enjoy the exclusive privilege of making stockings for the whole of my subjects is too important to grant to any individual."
But it gets much more s economically interesting
Apparently Lee ran into a different problem: Queen Elizabeth has been granting lots of monopolies to court favorites, and there was a widespread sense that it had gotten out of hand. Thus, the granting of unwarranted monopolies became a reason to deny Lee a monopoly as well. Henson writes:
"The time which Mr. Lee had chosen to make an application to the government, though to his sanguine mind very propitious for remuneration. was in reality the reverse; the treasury of Elizabeth was extremely low, owing to the enormous expenses which she had incurred in preparations to meet the Spanish armada in the preceding year. Already had the Parliament begun to express their decided umbrage at the grant of the privileges of patents for monopolies; which, as they were then conducted, were justly considered national evils, and the most odious means of rewarding court favorites, by an excessively tyrannical mode of private taxation. Nearly all the nobles enjoyed a patent for the most useful and general articles of consumption, such as iron, lead, saltpetre, salt, oil, glasses, &c. &c., to the amount of more than one hundred articles, which were sold, imported, or exported by virtue of letters patent. These patent rights, were sold to persons who farmed the profits, and thus demanded what prices they thought prudent for their commodities. [my emphasis] When the general list was read over in the House of Commons in 1601, a member, indignant at the the extortions, exclaimed, " Is bread amongst the number?" "Bread?" cried the house, with astonishment, "Yes I assure you," he sarcastically replied, "if we go on at this rate, we shall have a monopoly of bread before next Parliament."
Actually, I believe they did. Most trades were restricted to guild members and you couldn't just bake bread and sell it. (Historians, let me know if I'm confusing place and time here.)  "Patent" in 16th century England also seems to mean more a general monopoly right than our current understanding, as in a "patent" to sell iron. Lee went on to the French court, to try to get a patent and monopoly there too.

Lee never, apparently, made a bundle actually making stockings. He died unhappily in France, though his machine did get adopted. Just how long it took a simple stocking machine to be adopted may tell us something interesting about why economic growth was so slow to break out.

The interesting observation here: it's 1589, and you invent a cool new machine, say for making stockings. What do you do with it? You and I might answer, "start making stockings." You can undersell the competition and make a bundle. Or, we might answer, "start selling stocking-making machines." Sure, others will follow, but you have a big first-mover advantage. Yes, if a modern patent system were up and running it might be useful to get a patent and try to slow down competitors. But first and foremost, get the business going.

That Lee did not do this -- that it seems not even to have occurred to him - is telling about just how controlled and regulated economies apparently were at the time.

It brings to mind two other recent histories I read, Dava Sobel's Longitude and Charles Coulston Gillispies' book on the  Montgolfier Brothers.

Longitude: In the 1700s, it was a major problem to know how far east or west a ship was. After painstaking work, John Harrison came up with a solution: a clock that could tell time accurately, even at sea. What did he do with it? Start selling clocks to ship captains, you might say! And you would be wrong. He spent his life trying to get the prize established for that purpose, mostly unsuccessfully.

Balloons: The Montgolfier Brothers invent the balloon. What do they do with it? Start selling balloons? Start selling balloon rides? No, immediately off to Paris to get royal dispensation.

I don't know enough about these early economies, but that running off to get a Royal monopoly seems to be the only thing anyone even considers to do with a new invention seems interesting evidence on just how rigidly controlled economic affairs were.

Guilds, patents, monopolies, and the primary function of economic regulation being to create rents in return for political support, seems a pattern with deep roots.

## Thursday, March 14, 2019

### Competitive deposits?

In its death note to narrow banks (link to Federal Register where you can post comments; previous post),  the Fed claimed charmingly that retail deposit rates are fully competitive, so we don't need a narrow bank option to help spread the interest on reserves to deposit rates. In the Fed's view, the fact that banks pay so little compared to reserves just reflects the costs (many of them regulatory!) of servicing retail accounts.
"Some have argued that the presence of PTIEs could play an important role in raising deposit rates offered by banks to their retail depositors. The potential for rates offered by PTIEs to have a meaningful impact on retail deposit rates, however, seems very low...retail deposit accounts have long paid rates of interest far below those offered on money market investments, reflecting factors such as bank costs in managing such retail accounts and the willingness of retail customers to forgo some interest on deposits for the perceived convenience or safety of maintaining balances at a bank rather than in a money market investment.
Here is some data. From "The Deposits Channel of Monetary Policy"  by Itamar Drechsler  Alexi Savov  and Philipp Schnabl, The Quarterly Journal of Economics, 132 (2017)1819–1876:

When the Fed Funds rate rises, checking  account rates do not. (It's interesting that savings and time deposits do move more quickly, indicating banks face more competition there.) The Fed's story that the spread between checking account rates and federal funds (now IOER) rates reflects costs is very hard to square with this graph -- why should costs and benefits of checking accounts change over time so much, and coincidentally rise exactly one for one with the Federal Funds rate?

Pablo Kurlat, Deposit Spreads and the Welfare Cost of Inflation plots similar data cross sectionally, which lets you estimate the pass through rate better at the expense of the time pattern:

Pablo puts the spread between deposit and federal funds rate on the vertical axis. So, if banks passed through interest rates one for one, the line would be flat. If there were a constant cost, it would be flat but at a higher level. If banks pay the same lousy rate no matter what interest rates are, the curve lies on the 45 degree line. You can see the same general picture.

(Pablo's paper is very nice. He concludes that therefore the "Friedman rule" that interest rates should perpetually be zero, with slight deflation making real rates positive, has yet another thing going for it, that banks are not able to use their market power against us so much.)

Pablo also plots data from different countries:

It's interesting that Sweden and Italy have flatter (more competitive lines). It's really interesting that Argentina lies on the 45 degree line, with no pass through, despite huge inflation-induced interest rates. I would guess that Argentina has a law against paying interest rate on deposits, as the US used to have.

No, it strikes me we have exactly what it seems to be, looking out the window, a heavily regulated not very competitive oligopoly, sort of like airlines 1972.

## Wednesday, March 13, 2019

### Fed vs. Narrow Banks

Suppose an entrepreneur came up with a plan for a financial institution that is completely safe -- it can never fail, it can never suffer a run, it offers depositors perfect safety with no need for deposit insurance, asset risk regulation, capital requirements, or the rest, and it pays depositors more interest than they can get elsewhere.

Narrow banks are such institutions.  They take deposits and invest the proceeds in interest-bearing reserves at the Fed. They pay depositors that interest, less a small profit margin. Pure and simple. Economists have been calling for narrow banks since at least the 1930s.

You would think that the Fed would welcome narrow banks with open arms.

You would be wrong.

The latest chapter in the Fed's determined effort to quash The Narrow Bank (TNB) and at least one other effort to start a narrow bank is unfolding. (Previous posts here and here.)

Last year, TNB sued the Fed for refusing to allow TNB an account at the Fed at all. The Fed has just now filed a motion to dismiss the suit. The Fed has also issued an advance notice of proposed rule making, basically announcing that it would, on a discretionary basis, refuse to pay interest on reserves to any narrow bank. In case anyone gets a bright idea to take a small bank that already has a master account and turn it in to a narrow bank, thereby avoiding TNB's legal imbroglio, take note, the Fed will pull the rug out from under you.

I find both documents outrageous. The Fed is acting as a classic captured regulator, defending the oligopoly position of big banks against unwelcome competition, its ability to thereby coerce banks to do its bidding, and to run a grand regulatory bureaucracy, against competitive upstarts that will provide better products for the economy, threaten the systemically dangerous big bank oligopoly, and reduce the need for a large staff of Fed regulators.

I state that carefully, "acting as." It is my firm practice never to allege motives, a habit I find particularly annoying among a few other economics bloggers. Everyone I know at the Fed is a thoughtful and devoted public servant and I have never witnessed a whiff of such overt motives among them. Yet institutions can act in ways that people in them do not perceive. And certainly if one had such an impression of the Fed, which a wide swath of observers from the Elizabeth Warren left to  Cato Institute anti-crony capitalism libertarians do, nothing in these documents will dissuade them from such a malign view of the institution's motives, and much will reinforce it.

On the outrage scale, the first paragraph of the Fed's motion to dismiss takes the cake:

## Wednesday, January 30, 2019

### The death of the healthcare market

People really do not need health insurance for regular small expenses, as they do not need car insurance to "pay for" oil changes. And any insurance system relies on an underlying cash market to find what the right prices are. Collision insurance works reasonably well because there is a supply and demand market for auto repair in which people pay their own money and there are competitive suppliers and free entry, offering services along a wide quality-price spectrum.

The underlying cash market has disappeared in health care. If you try to just pay for service, you face the ridiculous sticker prices. Everyone needs to go through some sort of middleman. We have, collectively, fallen for the fallacy that "negotiation" can lower everyone's price, rather than (try to) lower my price by raising yours. It is widely recognized that catastrophic insurance plus health savings plans are a much better structure than current pay for everything structures. But you can't do that if people showing up on their own to buy things are faced with fictitious "list prices."

These thoughts come to mind reading an excellent explanation of the price of insulin posted by Novo Nordisk via Charles Sauer in the Washington Examiner (and thanks to a correspondent who sent the link)
".. the drug pricing system, .. is incredibly complex and has resulted in a lot of confusion around what patients pay for medicines...."
"As the manufacturer, we do set the “list price” ... However, after we set the list price, we negotiate with the companies that actually pay for the medicines, which we call payers. This is necessary in order for our medicines to stay on their preferred drug list or formulary. The price or profit we receive after rebates, fees and other price concessions we provide to the payer is the “net price.”... "
Perhaps it's clearest right there: "the companies that actually pay for the medicines, which we call payers." What happened to people?

Notice also the graph. If you think it's been getting a lot worse in a short time, you're right.

Right out in the open, and clear as a bell:
...those price increases were our response to changes in the healthcare system, including a greater focus on cost savings, and trying to keep up with inflation. PBMs and payers have been asking for greater savings – as they should. However, as the rebates, discounts and price concessions got steeper, we were losing considerable revenue... So, we would continue to increase the list in an attempt to offset the increased rebates, discounts and price concessions to maintain a profitable and sustainable business. ...

## Friday, January 25, 2019

### Privatize TSA and ATC!

In the aftermath of 9/11, there was some debate whether TSA should be federal employees, or run privately, and paid for by airlines. Government does not have to actually employ people in order to regulate, supervise, and make sure standards are followed.

Similarly, there has been a longstanding debate whether air traffic control should continue to be run by the federal government rather than privatized, as it is in Canada.

Now that TSA and ATC turn out to be the straws that break the camel's back on federal government shutdowns, perhaps it would be wise to revisit both decisions!

## Monday, January 21, 2019

An interesting question emerged from some discussion surrounding my last carbon tax post. How big will the tax be? The letter says $40 a ton, but then rising. But how far? And in response to what question? It occurs to me that the two obvious targets lead to radically different answers. 1) The social cost of carbon. This is what economists usually think of as the appropriate Pigouvian tax. In order to pollute, you pay the cost you impose on others by your pollution. Even the worst-case scenarios now put the cost of carbon emissions at 10% of GDP in the year 2100. Discount that back, divide by all the carbon emitted between now and then, and, you're going to get a pretty small tax. 2) Temperature or quantitative guidelines. Or, "whatever it takes to stop the global temperature from rising more than 1.5 degrees C." Such a tax has to be high enough to basically stop us from using fossil fuels. It would be radically higher, and impose economic costs far higher than 10% of GDP. When you set a goal of a quantity with no attached price, the price can get pretty high. I see now some of the back and forth chatter. Anti-carbon types warn that any tax "won't be enough." Now I know what they mean. So who sets the tax, and on what basis, are important issues we're all fudging over. Of course, a cynic would take the view that the tax will be set to 3) Maximize government revenue. Given the behavioral elasticities, that is likely to be a good deal less than #2, as to high a tax will quickly erode the tax base. PS: to my may CO2-is-not-a-problem commenters. If (or perhaps when) it's all proved to be a hoax, a carbon tax is a lot easier to undo than the alternative regulatory approach! ### Lend the shutdown? The Federal Government seems to be obeying with rather remarkable accuracy the constitutional mandate that the government may not spend money that has not been appropriated by Congress. I would be curious to hear from legal experts, however, what stops the government from lending money to federal employees, or just guaranteeing loans. After all the government lends money all over the place, and credit guarantees are even larger. Is the Treasury no longer operating small business loan programs? (Honest question.) Is the Fed no longer lending money to banks, if they want it? Are Fannie and Freddy refusing to buy home mortgages because the funds to guarantee home mortgages (which it does) are not appropriated? No. As far as I can tell, Federal lending and loan guarantee programs are up and running. If so, what stops the Treasury, from either lending money directly to Federal employees, or guaranteeing private lending. After all, the Treasury will write their back paychecks when the time comes, so these are potentially risk free loans. What stops the Treasury from just writing on a federal employees' paycheck "this is a loan against your back pay?" Or... Social security and Medicare are still running. Can they write advances against social security payments that will be deducted from future federal paychecks? I presume there is something stopping this -- that it is a step too clever, like the trillion dollar coin solution to the debt limit. But I would be curious to hear what the limitation is. (HT Marginal Revolution on federal employees' other sources of financing, at pretty high interest rates.) ## Saturday, January 19, 2019 ### Economists' letter on carbon The "Economists’ Statement on Carbon Dividends" in the Wall Street Journal this week is a remarkable document. It's short, sweet, and signed by, as far as I can tell, every living CEA chair, every living Fed Chair, both Democrat and Republican, and most of the living Nobel Prize winners. (Thanks to a commenter who corrected an earlier count.) It offers four principles 1. A carbon tax, initially$40 per ton. 2. The carbon tax substitutes for regulations and subsidies and (my words) the vast crony-capitalist green boondoggle swamp, which is chewing up money and not saving carbon. 3. Border adjustment like VAT have 4. "All the revenue should be returned directly to U.S. citizens through equal lump-sum rebates."

That the carbon tax is better than regulations and subsidies in choosing technology gets a lot of press. Yes, should we have rooftop solar cells or utility cells in the desert? Is it better to have battery powered cars or high speed trains? Do we really have to have washing machines that no longer actually clean clothes? And the only way to actually save lots of carbon -- nuclear -- has a much better chance under a carbon tax than hoping our political system will allow it.

But most people forget what economists know best -- that a carbon tax is the only way to change behavior. The answer to energy savings isn't as much new technology as in old behaviors. Turn the lights off. Take fewer trips. Turn the heat down. Move nearer your work. Carpool. Without a carbon tax there is no way for the average bleeding heart Palo Alto climate worrier to realize that one trip to Europe is like driving a car for 10,000 miles. (Planes get about 80 passenger miles per gallon -- but it's a lot of miles to Europe.) Twenty years ago, my then 8 year old daughter, reading about fuel economy standards, piped up "if they make cars more fuel efficient, it will be cheaper to drive. Won't people just move further away?" Indeed.

I try to sell a carbon tax deal to friends who are climate skeptics. Well, our government is going to do something. Given that fact, the carbon tax will cause much less damage than ever increasing regulations and subsidies. And I try to sell it to carbon warrior friends too. The tax instead of the regulations and subsidies, in our political system, is going to save you a lot more carbon.

The last proposal is, I think, the most contentious. Optimal taxation theory, as several of the signatories pointed out in other contexts, says that the carbon tax should go to reduce other distorting taxes. This will create more economic growth. As Holman Jenkins  put it,
A tax reform that included a carbon tax to replace taxes that depress work, saving and investment would be an incentive to do everything in a less carbon-intensive way, bringing forth new technologies
Here the authors step back from benevolent-planner optimums and think politically. Well, we live in a political system.

But there is a bright side. One big point of the dividend is to guarantee that revenues will not go to financing ever larger green boondoggles like the California high-speed train to nowhere, or to subsidize a Tesla in every VCs driveway. Carbon dividend means no "green new deal." The view that the tax system is what it is, and a major new source of revenue will not go to reducing marginal tax rates in a growth-oriented reform sounds quite realistic to me. If our Congress were interested in growth-oriented tax system it would already look a lot different than it is today.

A flat dividend is also immensely progressive. It is, effectively a universal basic income. And casual observation on ownership of large houses and jet travel suggests wealth people spew a lot more carbon than poor ones. I guess that is an effort to get Democrats to give up some of their cherished regulations and subsidies to get these long sought goals. (Like any UBI, it's going to make immigration a tougher issue, but we won't go there today.)

Tyler Cowen disagrees with the dividend.
"It strikes me as economists thinking they know what makes good politics, something which economists are rarely good at."
Well, he has a point, and I also think economists should emphasize more when they have expertise and when they don't. On the other hand, I don't see anybody else having much better idea what makes good politics these days, and the list of "economists" that created and signed the letter, starting with George Shultz, have immense political experience.

The dividend may not be the economically most efficient thing to do, but it will guarantee a lifetime of political support for the carbon tax! Hamilton figured this out with the assumption of national debt.

It has taken me some time to come around, as attached as I am to reducing marginal tax rates, but the political advantage that out keeps the money from being spent on boondoggles, and creates a constituency in favor of the tax and against spending the results on boondoggles, is strong.

I also worry about the wide range of environmental issues that have been forgotten in the Great Carbon War. Butterflies and Frogs are disappearing. The pacific garbage patch grows. Rhinos and Elephants will be gone long before climate bothers them. Take your pick, if we passed the carbon tax, and if this issue could disappear as one of the issues uniting partisanship and sweeping up the entire environmental movement, it would be a lot better for life on the planet.  Once upon a time, there were Republicans in the Sierra Club, Audubon Society, Greenpeace, and other formerly non-partisan organizations. Put carbon behind us, and it could be so again.

"Big Names Bake a Climate Pie in the Sky" complained Holman Jenkins. His complaint, largely, is that the deal won't be kept -- we'll get the tax and regulations, and the dividend promise will disappear into the bowels of Washington.
Besides, since we face a “climate emergency,” wouldn’t the money be better spent on speeding up deployment of wind and solar? As for existing mandates and subsidies, sure, we might expend additional political energy to repeal these. And pigs might fly.
This is an important point. As reducing marginal rates and removing deductions sounds nice, our tax reforms (especially the last) reduce marginal rates but don't remove deductions. The VAT with no income tax is a much better system, but many free market economists don't favor it because they don't trust the deal. Trusting the deal, carbon tax in return for no regulations, is a stretch.

However, I can hope that a deal could be struck, carbon tax in return for no new regulations and subsidies, or subsidy extensions -- no "Green New Deal."  If we give up that deals can ever be struck and kept, we might as well give up on democracy.

Of course, in the 5th week of a shutdown, over a completely symbolic issue, with great deals on the table that benefit both sides, if only each could let the other have a symbolic victory, is not a great time to advance such hope. But even here, once you realize the shutdown has nothing to do with immigration, you see hope. This is a battle to the end over the Trump presidency. If he backs down, his presidency is finished. The Democrats think they can achieve that, and if they back down their left wing takes over. There is no way out of that one -- and reason to hope that when Washington is bargaining over actual policy and not over a symbolic but life-and-death battle, that they can do it.

## Monday, January 14, 2019

### Volalitily, now the whole thing

An essay at The Hill on what to make of market volatility, from Dec 31. Now that two weeks have passed, I can post the whole thing. I add some graphs too.  (Though at the rate things are going any forecast will have been proved wrong in two weeks!)

What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year?

The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come?
Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility.  Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come.

Still, is this at last the time? A few guideposts are handy.

There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level.

Twenty percent volatility is normal. Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop.

Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason. If we knew with confidence that a recession would happen next year, businesses would not invest or hire, and people would not spend, and we’d have a recession now.

Recessions do have some momentum. But the cyclical indicators of the real economy are strong, much stronger than they were in 2007-2008. Unemployment is 3.7%. There is no slowdown in real GDP growth or industrial production, or business investment in the most recent data. Inflation is close to the Fed’s target, so there is little reason to fear the Fed will quickly raise rates and cause a recession. Now, the market aggregates more information and faster than the rest of us. Still, the lack of any slowdown adds weight to the suspicion that this correction may pass as well.

In thinking about the economy, remember that it has passed from “demand” to “supply.” At 3.9% unemployment, we cannot get greater growth from simply putting unemployed people and machines to work.

 The stages of the business cycle
As we complete the transition from a demand-limited economy to a supply-limited economy, it is perfectly natural for interest rates to rise. One or two percent above the inflation rate is perfectly normal. As interest rates rise, it is perfectly natural for interest-sensitive sectors like housing and autos to decline a bit – but other sectors do better. Demand shifts between products, and auto or housing slowdowns do not mean an overall slowdown.

The economy no longer needs or can use monetary or fiscal “stimulus.” Now growth must come more productivity. Growth-oriented policy requires efficiency, “structural reform,” better incentives, not just money in pockets. In my view, the US has gotten an extra percent of growth, mostly from deregulation and a bit from the incentive effects of the tax cuts. But these are over, and further reform is unlikely. So a growth slowdown is certainly in the cards.

What about the yield curve? It is flattening – the difference between long-term rates and short term rates is narrowing. And an inverted yield curve has, historically, been a good forecast of a recession to come.

But we are not yet at inversion, as the graph shows. Moreover, there have been long periods of nearly flat yield curves in the past, when the “supply” economy kept growing before the next recession, most notably the mid 1990s. In fact, if inflation remains contained, it is possible that the world starts to resemble earlier eras with permanently inverted yield curves. In a non-inflationary environment, long-term bonds are safer for long-term investors. Last, the form of inversion matters as well as the fact. An inversion that comes from the Fed quickly pushing up short rates to cause a slowdown, fighting inflation, is likely to, well, cause a slowdown. An inversion that comes when long-term rates plummet, seeing trouble ahead, is likely to be followed by trouble ahead. We have neither of those circumstances.

So what is going on? I hazard a guess.

Volatility occurs when there is great uncertainty. Investors are worried big events are on the horizon, and can’t quite figure out what is going to happen. Prices aggregate information, so seeing a price decline can make you think other people know something you don’t in a time of great uncertainty. We see this clearly in studies of high frequency data, when bond markets are adapting and digesting Fed statements, and we know there is no other news to react to.

We are, no doubt, in a time of high uncertainty about policy and politics. Volatility broke out almost coincident with the November election, and I think the markets are trying to digest just what the political chaos of the next two years means for the economy.

Surely no major growth-oriented economic reforms will come out of Congress. Congressional democrats will bring the full weight of the legal system against the Administration. Cabinet secretaries trying to clean up regulation will have a hard time when being constantly subpoenaed.

The government shutdown over 1/10 of 1% of the Federal budget devoted to a border wall is emblematic. It is, of course, entirely symbolic as any border wall will be stuck in the courts for decades. But it is precisely when issues are symbolic that compromise is impossible.

So the best economic news that markets can hope for is two years of complete government paralysis, and therefore a return to 2 percent or so growth.

Things could be much worse, and markets know it. A large policy blunder in the next two years, such as a big trade shock could well happen.

More deeply, the US is now unable to respond to any genuine crisis — economic, financial, military. Imagine that another banking crisis hits, and President Trump asks Congress, again, for a trillion bucks to bail out banks, and another trillion for fiscal stimulus. Or imagine if he does not, and whether the Administration can implement better ideas to fight a new and different crisis. Imagine what happens if China invades Taiwan, or a big bomb goes off in the middle east.

Europe is not in much better shape. It has followed the Augustinian approach to structural reform – Dear Lord, give me reform, but not quite yet. Italian banks, and too many German banks, are still stuffed with Italian government debt. Brexit, Cinque Stelle, and Gilets Jaunes mean that pro-market, free trade, growth-oriented structural reform not likely, and there is a limit to what even the ECB can do. China is as usual obscure, and more fragile than they want us to believe.

Throughout the world, government debt remains the big danger. Where is there a lot of debt, no plan to repay it, shady accounting, extend-and-pretend, off-balance sheet guarantees, and the debt is mostly short term and prone to runs? Government debt. If a serious recession comes, in a time of dysfunctional government, it may well provoke a government debt crisis, which would be an economic conflagration beyond anything we have seen.

So, we live in a time of great uncertainty, brought about by great political uncertainty. Great uncertainty leads to volatility. Volatility means that stocks are more risky, and thus must pay a greater expected return to get people to hold them. The only way for the expected future return to rise, is for today’s price to go down. So we see a correction – mild so far, to compensate for the mild risk of holding stocks through a few months of ups and downs.

There is a silver lining to this story. If prices are low because required returns have risen, then if nothing bad happens, long-term investors will do fine. Bond prices go down when yields go up, and the larger yields eventually make up for the price loss.

But greater uncertainty means a greater chance that something truly terrible will happen. As well as a greater chance that it won’t. The big message of the moment is that risk is higher. Managing risk, not following some sage’s directional bet, is the best investment advice anyone should start with.

(I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility.)

## Friday, January 11, 2019

### Property tax present value

How much is the property tax? In Calfornia, we pay 1%  per year.

That doesn't seem bad, except that property values are very high. You can't get a tear-down in Palo Alto for under $2 million. If you buy a house that costs 5 times your income -- say someone earning$200,000 per year buying a $1 million house -- then that is equivalent to 5 percentage points additional income tax. On top of 42% federal, 13.2% state, 9% sales, and other taxes, it's part of my view that we're past 70% top marginal rate now. The other way to look at taxes is in present value. At 1% interest rate, the value of a 1% payment is$1.00. What that means: Suppose you bought a $1,000,000 house. It's going to cost you$10,000 in property taxes per year. Let's set up an account that will pay your property taxes. If you get 1% interest on that account, you need to put $1,000,000 in the account! A 1% property tax at a 1% interest rate is equivalent to a 100% tax on houses. That$1,000,000 house is really going to cost you $2,000,000! There is a general paradox here: The top two things our politicians say they want to encourage are jobs and homeownership. Jobs are perhaps the most highly taxed economic activity in the economy, and by this calculation houses come in a close second. (California also assesses a 1% personal property tax, on top of a sales tax, for anything they can prove you own, which usually means boats and airplanes. That too is an additional 100% tax.) The second lesson, the value of wealth taxes depends sensitively on the interest rate, as I'm sure some of you are chomping at the bit to point out. If the interest rate is 2%, then the tax rate is "only" 1/0.02 = 50%. If the interest rate is 5%, then the tax rate is 1/0.05 = 20%. I suspect these taxes were put in place in a time of higher interest ares and nobody is really thinking about the effect of lower rates. Similarly, suppose the government puts in a 1% per year wealth tax. If wealth generates a 5% rate of return, then the 1% wealth tax is the same thing as a 20% one-time confiscation of value*. If wealth generates a 1% rate of return, a 1% wealth tax is a 100% confiscation of value**. Mercifully, our income tax system taxes the rate of return, not the principal, and avoids this conundrum. Others do not. What is the right rate? We can have a lot of fun with that one. The current 30 year TIPS (inflation indexed) rate is 1.19%. The 30 year nominal Treasury rate is 2.97%. In California, under Proposition 13, you pay 1% of the actual purchase price per year, but that quantity never increases. (This fact results in the paradox of extremely high property taxes on new purchasers, older people staying in huge old houses, and low property tax revenues.) So you might say that the nominal rate applies. In Illinois, you pay a percentage of assessed value, which is usually a good deal lower than the actual value. (It also leads to a fun game of fighting over what the assessed value is. No surprise some of Illinois' most powerful politicians are also lawyers whose firms argue property assessment cases. ) That means however that the real interest rate matters. But in both cases, we need to use the after-tax rate. If you put your money in a 30 year treasury (or a long-term bond fund that keeps a long maturity), you pay taxes on the interest. If your marginal tax rate (federal + state + local) is 50%, that means you only get half the interest. So that 3% nominal yield is really a 1.5% nominal yield, and the Californian should use a 1.5% rate, resulting in a 1/0.015 = 66% tax rate. The tax treatment of TIPS is more complicated. (Really, inflation protected bonds are a great idea, but did the Treasury have to screw up the tax treatment so thoroughly?) You pay taxes on the nominal interest payments, and also on increases in principal value. This causes an accounting mess that I don't want to get into here, but as a rough guide, if you are in a 50% marginal tax bracket, then you need to buy$200 worth of TIPS to generate a \$1.00 after-tax stream. So, if you live in a state where property tax assessments rise over time, we're really talking about 2  x 1/0.01 = 200% tax rate on the initial assessed value.

Now, house prices rise more than inflation. That argues for an even higher present value of taxes.

On the other hand, you're not going to keep your house forever. But you will sell it, and the price reflects the property tax. On one extreme, if there is no house supply, then the price reflects the full property tax. Without property tax, you could sell it for double the current value. Then these calculations are right. That's a good approximation for Palo Alto. If house supply is flat, then the house price equals construction costs, and we need to cut off these present values at your horizon for owning the house.

The back of my envelope is full.

I'm not very good at taxes, so I welcome comments and corrections on this.  Also if it's all standard stuff, send a pointer to the source.

*sum_j=0^inf (0.05 - 0.01)/(1.05)^j = 0.04/0.05 = 0.80 = (1-0.20) x sum_j=0^inf 0.05 / (1.05)^j

**sum_j=0^inf (0.01 - 0.01)/(1.01)^j = 0 = (1-1) x sum_j=0^inf 0.01 / (1.01)^j

Update: Thanks to several commenters who point out that California property tax rises at the lesser of inflation or 2%. This means that the lower real interest rate is the right discount rate, not the higher  nominal interest rate.