Thursday, June 14, 2018

Different Planets

A friend, who reads an unusually diverse set of sources, passed on some interesting pictures suggesting that our media live on different planets.

On the Trump-Kim summit


On the investigations:


Tuesday, June 12, 2018

Cross-subsidies

Cross-subsidies are an under-appreciated original sin of economic stagnation. To transfer money from A to B, it would usually be better to raise taxes on A and to provide vouchers or otherwise pay competitive suppliers on behalf of B. But our political system doesn't like to admit the size of government-induced transfers, so instead we force businesses to undercharge B. Since they have to cover cost, they must overcharge A. It starts as the same thing as a tax on A to subsidize B. But a cross-subsidy cannot withstand competition. Someone else can give A a better price. So our government protects A from that competition. That ruins the underlying markets, and next thing you know everyone is paying more for less.

This was the story of airlines and telephones: The government wanted to subsidize airline service to small cities, and residential landlines, especially rural. It forced companies to provide those at a loss and to cross-subsidize those losses from other customers, big city connections and long distance. But then the government had to stop competitors from undercutting the overpriced services. And as those deregulations showed, the result was inefficiency and high prices for everyone.

Health care and insurance are the screaming example today. The government wants to provide health care to poor, old, and other groups. It does not want to forthrightly raise taxes and pay for their health care in competitive markets. So it forces providers to pay less to those groups, and make it up by overcharging the rest of us. But overcharging cannot stand competition, so gradually the whole system became bloated and inefficient.

A Bloomberg article "Air Ambulances Are Flying More Patients Than Ever, and Leaving Massive Bills Behind" by  John Tozzi offers a striking illustration of the phenomenon, and much of the mindset that keeps our country from fixing it.

The story starts with the usual human-interest tale, a $45,930 bill for a 70 mile flight for a kid with a 107 degree fever.
At the heart of the dispute is a gap between what insurance will pay for the flight and what Air Methods says it must charge to keep flying. Michael Cox ... had health coverage through a plan for public employees. It paid $6,704—the amount, it says, Medicare would have paid for the trip.   
The air-ambulance industry says reimbursements from U.S. government health programs, including Medicare and Medicaid, don’t cover their expenses. Operators say they thus must ask others to pay more—and when health plans balk, patients get stuck with the tab.
Seth Myers, president of Air Evac, said that his company loses money on patients covered by Medicaid and Medicare, as well as those with no insurance. That's about 75 percent of the people it flies. 

Source: Bloomberg.com
According to a 2017 report commissioned by the Association of Air Medical Services, an industry trade group, the typical cost per flight was $10,199 in 2015, and Medicare paid only 59 percent that. 
So, I knew about cross-subsidies, but $45,950 vs. $6,704 is a lot!

OK, put your economics hats on. How can it persist that people are double and triple charged what it costs to provide any service? Why, when an emergency room puts out a call, "air ambulance needed, paying customer alert" are there not swarms of helicopters battling it out -- and in the process driving the price down to cost?

Monday, June 11, 2018

Summer School Suggestion

The Asset Pricing online class is back, now hosted on Canvas. This is a first-year PhD level course in asset pricing. Advanced undergraduates and MBAs with some economics and basic calculus can take it too.  I mention it again as it is well suited as a summer school project, and I realized in talking to colleagues that not everyone who knew about the original class knows it's alive again.  Go here to sign up.

Faculty can also assign it or parts of it, and using the canvas system find out if students have taken the quizzes. This makes it a useful summer school prerequisite for fall classses, or you can use it or parts of it in a flipped classrom -- have the students do an online unit, take the quiz, and then show up to class prepared for more advanced discussion.

More information here on my webpage, along with all the videos and notes, and lots of extra material. If you don't want to take the quizzes, you can see the videos and notes without taking the course.

Monday, June 4, 2018

ACA dropouts

Half of the people who sign up for Obamacare (ACA) get a flurry of medical care, then drop out before a year is over. They can always sign up again if they need to. People who stay on insurance tend to be those who have ongoing chronic and expensive conditions that need continual care. The implications for the viability of such insurance are not good.

This is the interesting conclusion of a new paper, "Take-Up, Drop-Out, and Spending in ACA Marketplaces" by Rebecca Diamond, Michael Dickstein, Tim McQuade, and Petra Persson. One good summary graph:



Tuesday, May 29, 2018

Lessons of the ELB

I gave a short presentation on monetary policy at the Nobel Symposium run by the Swedish House of Finance. It was an amazing conference, and I'll post a blog review as soon as they get the slides up of the other talks. Offered 15 minutes to summarize what I know about the zero bound, as well as to comment on presentations by Mike Woodford and Stephanie Schmitt-Grohé, here is what I had to say. There is a pdf version here and slides here. Novelty disclaimer: Obviously, this involves a lot of recycling and digesting older material. But simplifying and digesting is a lot of what we do.


Lessons of the long quiet ELB
(effective lower bound) 


We just observed a dramatic monetary experiment. In the US, the short-term interest rate rate was stuck at zero for 8 years. Reserves rose from 10 billion to 3,000 billion. Yet inflation behaved in this recession and expansion almost exactly as it did in the previous one. The 10 year bond rate continued its gentle downward trend unperturbed by QE or much of anything else.

Europe's bound is ongoing with the same result.

Saturday, May 26, 2018

Jitters

Or, "the beginning of the end, or the end of the beginning?" Or, "from demand to supply?"

An Op-Ed for The Hill with some extras:


The economic expansion and stock market runup have been going on for a decade, and a case of the jitters seems to be spreading. How long can this go on? Is the end around the corner?

After years of quiet, the stock market suddenly became volatile again last March. Volatility is a sign of uncertainty, and often presages a decline. Stock prices are high relative to earnings and dividends, which often precedes a fall. Short term interest rates have risen, and long term rates and short term rates are nearly the same. An inverted yield curve, when short term rates are higher than long term rates, is one of the most reliable warning signs of a recession. The unemployment rate is down to 3.9%, a level that historically has only happened at business cycle peaks — that were soon followed by troughs. House prices and credit are up too, as they were at recent peaks. Is it time to worry?


Friday, May 18, 2018

Alexander Hamilton's solar panels

I think I finally have figured out why California is mandating solar panels on top of houses. (WSJ story here.)

As energy, environmental, or housing policy, it borders on the absurd, as pretty much everyone quickly figured out.

Just to recap, remember that most rooftop solar does not power the house underneath it. The energy goes out to the grid. Why not, you ask? Well, the rooftop energy comes at the wrong time, and we don't yet have economical storage, so you have to be connected to the grid anyway. Given that, the costs of switches to let the roof partially power the house at sometimes, power the grid at other times, is not worth the zero benefit. After all, electricity is electricity and your light bulb does not care where it came from.

So rooftops are just a place to put the electric utility's solar panels. Now let's consider, where is the best place to put solar panels that feed the grid?

Option A:


(OK, in reality the Mojave desert, or the vast stretches of wasteland along I-5 pockmarked with angry farmer billboards, but the camels are cute.)

Option B: The roof of a typical northern California house:
http://www.redwoodhikes.com/Dewitt/Dewitt.html

(OK, I'm having fun with this one, but you get the point. Actually a house off the grid is one place where rooftop solar does make a lot of sense, but you don't have to force people to buy them in that case.)

To belabor the point, people like to build houses near trees. Trees shading roofs are heavily protected in Palo Alto where I live, and you risk massive fines if you cut one down. House roofs don't always pitch to the southwest at the optimum angle.

A house is an expensive and flammable structure for a solar panel. You need to be a lot more careful putting it up there than out in the desert. In California especially, each installation needs a separate design, design review, permits, and so on. Code requirements are stringent. Each installation needs big switches, where the fire department can get at them (and a separate one for the battery). Each house needs a separate set of switches to connect to the grid. All of these fixed costs are spread way out on a commercial solar farm out in the desert.

And so on. We don't operate tiny coal burning generators in each house for the same good reasons.

So why is California doing it? Grumpy free marketers tend to bemoan nitwit liberalism, but economics teaches us to look for rational maximizing actors even in government.

So here is a suggestion. It's actually a brilliant move. Large-scale rooftop solar is only sustained by subsidies -- tax credits for installation and the requirement that homeowners can sell power to their fellow citizens (through the utility) at above-market rates. To put the matter mildly, not everybody thinks these subsidies are a good idea, and moreover you can't count on Washington to maintain subsidies for the 30 year lifespan of solar panels. You never know, someone like, say, Donald Trump might get elected president and start tearing apart energy subsidies.

So, once solar panels are on the rooftops of thousands of registered voters, you have a natural constituency that will vote and otherwise pressure the state, the administration, congress, and agencies to continue solar subsidies. 

The Alexander Hamilton story is that he wanted the US federal government to take on the state debts from the revolutionary war, in part to create a class of bondholders who would support the federal government's ability to raise taxes, to pay off that debt. Putting solar panels on houses, though ridiculously inefficient from an energy or environment point of view, achieves the same thing, in a nefarious sort of way.

Too bad they can't just give each of us a solar panel out in the desert, the way some charities show you "your" child in some third-world country. Once a year, you get a card "Happy holidays! I'm your solar panel, number 3457 in the Mojave desert. I've had a great year pumping out electricity! Here is your check for $357.52 in subsidies and power generation. Remember to vote on election day!"

Tuesday, May 15, 2018

Meditation on a trip to the DMV

I arrived at the DMV yesterday at 9 AM. My number came up at 5:45 -- you have to wait anxiously all day as you have 10 seconds to respond to your number. At 6:05, 10 hours after arrival. I was informed it was too late to take my written test so I would have to come back. As usual the place was packed, no food, no drink, two filthy restrooms.

(California has an appointment system but it takes two months to get an appointment, so if you need something now or can't book a free day two months ahead of time, you wait. 10 hours. Then you still get an appointment to return two weeks later as they won't get to you.)

Despite 13.2% top income tax rate, 7.5-9.5% sales tax, gas taxed to $3.80 a gallon, California cannot operate a functional DMV. Even Illinois, good old corrupt, bankrupt, Illinois, can operate a vaguely functional DMV. (Direct election of the secretary of state may have something to do with that.)

Estonia, this is not. Piles of paper flow around. Technology is about 1992 -- there is a number system, so you don't stand in line for 10 hours. But no indication where you are in the queue or when they might get to you.

Rebellion was in the air. Most people do not have my time flexibility. The very nice lady next to me had taken the day off work and had to arrange child care, which was going to end at a finite time. This was her second day of waiting. She was ready to start the revolution.

This is not unusual. It's just a completely normal day down at the DMV.

The joke has been around a long time: Do you really want the people who run the DMV to operate your health care and insurance system? But it is a good joke. The DMV is the main interface most people have  with the functioning or lack thereof of a bureaucracy.

The irony is that the democratic candidates in California are falling all over themselves to be stronger on "single-payer" health -- which does not just mean one fallback, but that all others are banned.

The amazing thing is that citizens of this noble state are all for it, though they must, like me, each take their turn in the 10 hour line at the DMV. (I suspect many high income progressives do not realize that "single payer" means them too. No concierge medicine.)

Republicans: I suggest you set up tables outside the DMV. After all, there is motor voter registration and this might get people in a good frame of mind for your message.

Second thought: Things could be worse. The DMV is  good proxy for the quality of government institutions. In many countries in the world you must pay a bribe to get a driver's license. In many other countries you can pay a bribe to cut through swaths of paperwork. At least in the US you can't do that.

But there are countries where government actually works. When our friends on the left dream of Scandinavian health care, perhaps they should visit a Scandinavian DMV first, and agree that let's see if our government can run a DMV before it tackles health care. And don't go after me with taxes -- the cost of a functional DMV is not that high. This one just needs to expand to match the growth in its population and the complexity of the various laws it has passed.


Friday, May 11, 2018

Argentina update and IMF

From Alejandro Rodriguez, my correspondent from the last post
We are ***! People are withdrawing funds from fixed income mututal funds (which hold ARS 300 billion of CB short term debt). Yestedary alone people withdrew 4% from those funds and ran to the dollar today. Peso falls 5% to $24.00 ARS/USD. Next step is a ran against term deposits in banks. Next tuesday the CB has to roll over ARS 680 billion of short term debt. A conservative estimate is that ARS 150 billion will not be rolled over and will ran immediatelly to the dollar. No IMF bailout will stop the crisis but it will definitively help us in the aftermath.

PS: If you want to know what interest rates are now (like if anyone cares about them anmore)

maturity APR 5 days 81% 41 days 45%

PS2: CB trying to control the FX as I write email. Down to $23.00 ARS/USD.
Coincidentally, as Argentina started this spiral, I was at the Hoover conference on "Currencies, Capital, and Central Bank Balances," and thinking about it especially during the session on "Capital Flows, the IMF’s Institutional View and Alternatives" featuring Jonathan Ostry, who bravely came to defend the IMF's Institutional View, Sebastian Edwards, and John Taylor, moderated by George Shultz.

Briefly, in the good old days, the IMF was solidly for the Postwar Order that viewed capital restricitons -- laws stopping people from investing in a country or taking their investments out -- were bad things and to be avoided at all times.

That changed, and the new view, as summarized compactly by John Taylor, is much more friendly toward "capital flow management":
what is new about the Institutional View is that “capital flows require active policy management,” which includes “controlling their volume and composition directly using capital account restrictions.” (p. 8) The Institutional View document (IMF 2012) defines key terms and gives examples. For example,.. CFMs thus include “capital controls” that “discriminate on the basis of residency” and macro-prudential policies that differentiate on the basis of currency (p. 40). ..[The quotes and page numbers in the next two paragraphs are from Ghosh, Ostry, and Qureshi (2017).]
As Ostry explained, the new view also includes a stronger reliant on fiscal stimulus tools to counter domestic difficulties.

My obvious thought, is just how much would Argentina's problems be solved by more capital flow management, currency restrictions, investment restrictions, fiscal stimulus and so forth. And whether the IMF, if it rides to the rescue, will suggest more such dirigisme for its bailout money. The old IMF view -- commit to openness, fix your budget problems, and a somewhat jaundiced view of the ability of even well intentioned central bankers to execute masterstrokes of technocratic "management"  -- might have something to go for it still.

(It's worth remembering that capital cannot flow in aggregate. The only way capital can leave a country is on boats.  You can sell a factory to a local at a low price, and you can sell the foreign currency for dollars at a low price, but you cannot move a factory once built and someone else has to buy the foreign currency and give you dollars. Capital and trade accounts must balance. Capital cannot flow in the short run. Prices can change.

"Flow management" is one of those soothing NGO acronyms for what is in fact property seizure. You can tell I'm not favorably predisposed)


Friday, May 4, 2018

Groundhog day in Argentina

My friend and colleague Alejandro Rodriguez, director of the Department of Economics at CEMA in Buenos Aires, wrote me a few emails that Argentina seems to be blowing up again in very interesting and sad ways. I haven't seen any coverage in the US media.
Argentina is going through some fun times (for macroeconomists)... After a two day holiday markets opened yesterday and the peso kept falling (-3%) despite the rate hike (300bps) on friday and the continued drain of reserves. We are trapped with Bill Murray in Groundhog Day. Same thing today... markets open with pressure on the peso. The central bank sold 300 millon of reserves in less than 10 minutes early in the morning when liquidity is at its lowest and it couldn´t sopt the run. Soon after it announced another rate hike of 300bps. Short term debt that expires on may 16 has a yield of 38.7% APR and there are 680 billon pesos of it waiting to mature in less than two weeks. Still the market did not respond and the peso kept falling, more than 8% with respect to yesterday´s close....
Naturally my interest is particularly peaked by a country whose central bank seems powerless to stop inflation and devaluation in a time of fiscal stress. In fact, there are indications that raising interest rates, by making interest costs larger, make the fiscal problem worse and make devaluation worse, not better.

I asked Alejandro for a bit more to share with blog readers since we hear so little about this in the US. Here is his longer story backward:


Groundhog Day: ...Like Phil Connors (Bill Murray) we got trapped in Punxsutawney by the perfect storm. Last year Congress passed a law changing the tax code which included a new tax on Central Bank debt held by non residents. The new tax became effective on April 25th. The new tax initiated a sell off by non residents which was absorbed by the CB which sold USD 2.1 billon between April 23rd and 25th without the dollar moving one cent (20.25 ARS/USD). The new tax coincided with the increase of the 10 year US treasuries yield and the strengthening of the dollar. The CB thought this was an external shock and that no further actions were going to be needed.

Wednesday, May 2, 2018

DB warns of US debt crisis.

"A coming debt crisis in the US?" warns a Deutsche Bank report* by Quinn Brody and Torsten Slok.

Source: DB
This graph is gorgeous. US deficits have, historically, been driven overwhelmingly by the state of the business cycle, and have very little to do with tax policies and spending decisions that dominate press coverage. In booms, income rises, so tax rate times income rises. In busts, the opposite, plus "automatic stabilizer" spending kicks in.

Until now.

There is a good reason past deficits did not really spook markets. They understood the deficit was a temporary phenomenon, due to temporary poor demand-side economic performance. We do not have that excuse now.

In case you thought this was some alarmist crank sheet, the report starts by quoting the latest CBO
report:
the CBO argues that, assuming current policies and trends are not changed, “the likelihood of a fiscal crisis in the United States would increase. There would be a greater risk that investors would become unwilling to finance the government’s borrowing unless they were compensated with very high interest rates.” 

Tuesday, May 1, 2018

What's worse than tariffs?

Quotas.

This morning's Wall Street Journal "Trump postpones steel tariff decision.." starts optimistic
President Donald Trump eased trade pressure on top U.S. allies Monday, giving the European Union and some nations outside the bloc more time to negotiate deals that would exempt them from U.S. steel and aluminum tariffs..
But it turns out those "deals" are worse than the original
The Trump administration is backing broad restrictions on the trade of metals to limit the direct and indirect effects of Chinese steel and aluminum production on the U.S. market. “In all of these negotiations, the administration is focused on quotas that will restrain imports, prevent transshipment, and protect the national security,” the White House said in a statement. 
Quotas are worse than tariffs. With a tariff, you can at least measure and limit the damage. Imported steel pays a tax, and then costs 25% more.  But you can import as much of the stuff as you need, and the damage is limited to a 25% price rise.

(On that word. Free traders should insist on "import tax" rather than "tariff" to remind taxophobic Republicans just what they are doing.)

With a quota, by contrast, the price difference can get as big as it wants and so the damage can grow unbounded. Moreover, it's harder to see -- you have to look at exchange-rate adjusted price indices which people can ignore as one more government statistic. When you pay 25%, you see it.

Saturday, April 28, 2018

EPA, the nature of regulation, and democracy

My Hoover colleague Richard Epstein posted a revealing essay on the nature of environmental regulation last week, with environmental regulation as a particular example. The contrast with "Environmental Laws Under Siege: Here is why we have them"  in New York Times  and the New Yorker's  Scott Pruitt's Dirty Politics is instructive

Epstein's point is not about the raw amount of or even what's in the regulation, but the procedure by which regulation is imposed:
As drafted, NEPA [National Environmental Policy Act of 1970 ] contains no provision that allows private parties to challenge agency decisions in court. Instead, the NEPA approval process is a matter for internal agency consultation and deliberation that takes into account comments submitted by any interested parties. 
One year after its passage, NEPA was turned upside down in a key decision by Judge J. Skelly Wright of the D.C. Circuit Court of Appeals... Wright read the law as giving private parties the right to challenge government actions. Indeed, Wright welcomed such challenges, writing (admiringly) that the change, “promises to become a flood of new litigation—litigation seeking judicial assistance in protecting our natural environment.”
Giving private parties the right to challenge an agency decision grants enormous leverage to the private parties most opposed to letting projects go forward. In the case of nuclear power, delay became the order of the day, as the D.C. Circuit on which Judge Wright sat arrogated to itself the power to find that any EA or EIS was insufficient in some way, so that the entire project was held up until a new and exhaustively updated EIS was prepared—which could then be duly challenged yet again in court.

Thursday, April 26, 2018

Conference on the cross section of returns.


The Fama-Miller Center at Chicago Booth jointly with EDHEC and the Review of Financial Studies will host a conference on September 27–28, 2018 in Chicago, on the theme “New Methods for the Cross Section of Returns.” Conference announcement here and call for papers here.

Papers are invited for submission on this broad theme, including:
  • Which characteristics provide incremental information for expected returns?
  • How can we tame the factor zoo?
  • What are the key factors explaining cross-sectional variation in expected returns?
  • How many factors do we need to explain the cross section?
  • How can we distinguish between competing factor models?
  • Do anomaly returns correspond to new factors?  
Why a blog post for this among the hundreds of interesting conferences? Naked self-interest. I agreed to give the keynote talk, so the better the conference papers, the more fun I have! 

This is, I think, a hot topic, and lots of people are making good progress on it. It's a great time for a conference, and I look forward to catching up and trying to integrate what has been done and were we have to go. 

My sense of the topic and the challenge: (Some of this reprises points in "Discount rates," but not all) 

Both expected returns and covariances seem to be stable functions of characteristics, like size and book/market ratio. The expected return and covariance of an individual stock seems to vary a lot over time. So we need to build ER(characteristics) and then see if it lines up with covariance(R, factors | characteristics), where factors are also portfolios formed on the basis of characteristics. 

Sunday, April 22, 2018

Basecoin

Cryptocurrencies like bitcoin have to solve two and a half important problems if they are to become currencies: 1) Unstable values 2) High transactions costs 2.5) Anonymity.

I recently ran across Basis and its Basecoin, an interesting initiative to avoid unstable values. (White paper here.)

Basecoin's idea is to expand and contract the supply so as to maintain a stable value. If the value of the basecoin starts to rise, more will be issued. If it falls, the number will be reduced.

So far so good. But who gets the seignorage when basecoins are increased? And just what do you get for your basecoins if the algorithm is reducing the numbers? From the white paper:
If Basis is trading for more than $1, the blockchain creates and distributes new Basis. These Basis are given by protocol-determined priority to holders of bond tokens and Base Shares, two separate classes of tokens that we’ll detail later. 
If Basis is trading for less than $1, the blockchain creates and sells bond tokens in an open auction to take coins out of circulation. Bond tokens cost less than 1 Basis, and they have the potential to be redeemed for exactly 1 Basis when Basis is created to expand supply.
Aha, basecoins get traded for ... claims to future basecoins?

You should be able to see instantly how this will unwind. Suppose the algorithm wants to reduce basecoins. It then trades basecoins for "basecoin bonds" which are first-inline promises to receive future basecoin expansions. But those bonds will only have value during temporary drops of demand. If there is a permanent drop in demand, the bonds will never be redeemed and have no value.  They are at best claims to future seignorage. Any peg collapses in a run, and the run threshold is mighty close here.

But it gets worse.

Thursday, April 19, 2018

Q is better than you think


This lovely graph comes from "Learning and the Improving Relationship Between Investment and q" by Daniel Andrei, William Mann, and Nathalie Moyen. The careful investment and q measurement make it much better than similar figures I've made for example Figure 4 here. Their paper explores the puzzle, just why did q theory work worse before 1995?

The graph also bears on the "monopoly" debate. Corporations are making huge profits, stocks are high, yet we don't see investment, the story goes -- marginal q must be much less than average q, indicating some sort of fixed factor or rent. Not in the graph.

Wednesday, April 18, 2018

Buybacks redux

Two more points occur to me regarding share buybacks. 1)When buybacks increase share prices, and management makes money on that, it's a good thing. The common complaint that buybacks are just a way for managers to enrich themselves is exactly wrong. 2) Maybe it's not so good that banks are buying back shares.  3) The tax bill actually gives incentives against buybacks. What's going on is despite, not because.

Recall the example. A company has $100 in cash, and $100 profitable factory. It has two shares outstanding, each worth $100. The company uses the cash to buy back one share. Now it has one share outstanding, worth $100, and assets of one factory. The shareholders are no wealthier. They used to have $200 in stock. Now they have $100 in stock and $100 in cash. It's a wash.

Why do share prices sometimes go up when companies announce buybacks? Well, as before, suppose that management had some zany idea of what to do with the cash that would turn the $100 cash into $80 of value. ("Let's invest in a fleet of corporate Ferraris"). Then the stock would only be worth $180 total, or $90 per share. Buying one share back, even overpaying at $100, raises the other share value from $90 to $100.

That was the big point. Share buybacks are a good way to get money out of firms with no ideas, into firms with good ideas. We want firms to invest, but we don't necessarily want every individual firm to invest. That's the classic fallacy that I think it turning Washington on its head. Best of all we want money going from cash rich old companies to cash starved new companies. Buybacks do that.

1) Management getting rich on buybacks is good.

OK, on to management. Management, buyback critics point out, often has compensation linked to the stock price. They might own stock or own stock options. So when the buyback boosts the stock price, then management gets rich too. Aha! The evil (or so they are portrayed) managers are just doing financial shenanigans to enrich themselves!

The fallacy here, is not stopping to think why the buyback raises the share price in the first place. If it is the main reason given in the finance literature, that this rescues cash that was otherwise going to be mal-invested, then you see the great wisdom of giving management stock options and encouraging them to get rich with buybacks.

Friday, April 13, 2018

Fiscal theory of monetary policy

Teaching a PhD class and preparing a few talks led me to a very simple example of an idea, which I'm calling the "fiscal theory of monetary policy." The project is to marry new-Keynesian models, i.e. DSGE models with price stickiness, with the fiscal theory of the price level. The example is simpler than the full analysis with price stickiness in the paper by that title.

It turns out that the FTPL can neatly solve the problems of standard new Keynesian models, and often make very little difference to the actual predictions for time series. This is great news. A new-Keynesian modeler wanting to match some impulse response functions, nervous at the less and less credible underpinnings of new-Keynesian models, can, it appears, just change footnotes about equilibrium selection and get back to work. He or she does not have to throw out a lifetime of work, and start afresh to look at inflation armed with debts and deficits. The interpretation of the model may, however, change a lot.

This is also an extremely conservative (in the non-political sense) approach to curing new-Keynesian model problems. You can keep the entire model, just change some parameter values and solution method, and problems vanish (forward guidance puzzle, frictionless limit puzzle, multiple equilibria at the zero bound, unbelievable off-equilibrium threats etc.) The current NK literature is instead embarked on deep surgery to cure these problems: removing rational expectations, adding constrained or heterogeneous agents, etc. I did not think I would find myself in the strange position trying to save the standard new-Keynesian model, while its developers are eviscerating it! But here we are.

The FTMP model

(From here on in, the post uses Mathjax. It looks great under Chrome, but Safari is iffy. I think I hacked it to work, but if it's mangled, try a different browser. If anyone knows why Safari mangles mathjax and how to fix it let me know.)

Here is the example. The model consists of the usual Fisher equation, \[ i_{t} = r+E_{t}\pi_{t+1} \] and a Taylor-type interest rate rule \[ i_{t} = r + \phi \pi_{t}+v_{t} \]
\[ v_{t} =\rho v_{t-1}+\varepsilon_{t}^{i} \]
Now we add the government debt valuation equation \[ \frac{B_{t-1}}{P_{t-1}}\left( E_{t}-E_{t-1}\right) \left( \frac{P_{t-1}% }{P_{t}}\right) =\left( E_{t}-E_{t-1}\right) \sum_{j=0}^{\infty}\frac {1}{R^{j}}s_{t+j} \]
Linearizing \begin{equation} \pi_{t+1}-E_{t}\pi_{t+1}=-\left( E_{t}-E_{t+1}\right) \sum_{j=0}^{\infty }\frac{1}{R^{j}}\frac{s_{t+j}}{b_{t}}=-\varepsilon_{t+1}^{s} \label{unexpi} \end{equation} with \(b=B/P\). Eliminating the interest rate \(i_{t}\), the equilibrium of this model is now \begin{equation} E_{t}\pi_{t+1} =\phi\pi_{t}+v_{t} \label{epi} \end{equation}
\[ \pi_{t+1}-E_{t}\pi_{t+1} =-\varepsilon_{t+1}^{s} \]
or, most simply, just \begin{equation} \pi_{t+1}=\phi\pi_{t}+v_{t}-\varepsilon_{t+1}^{s}. \label{equil_ftmp} \end{equation}

Here is a plot of the impulse response function:

Thursday, April 12, 2018

Intellectual property

The China trade argument has boiled down to intellectual property and trade. Roughly it has gone like this:
"We need to stop China from selling us all this stuff. Bring the jobs home!" 
"Uh, right now the jobs problem is that employers can't find workers. Cheap stuff from China is a boon to American consumers. Tariffs like that on steel cost more steel-using jobs than they save."  
"Hm. Ok, but we have to threaten with tariffs to get China to stop requiring our companies to share intellectual property!" 
I'm still skeptical about the intellectual property and trade argument. OK, suppose China says that in order for a US company to produce there, it must share intellectual property with a Chinese partner. Just how terrible is this? Just how terrible for the US economy, and society as a whole, justifying a robust policy response -- obviously the company would rather make more profits, but that's not a basis for economic policy.

Intellectual property is different from real property, in that it is nonrival. If you live in my house, I can't live in it. But if you use my equation, my blueprints, my recipe for nanoscale lubricants,  or my designs for specialty oilfield equipment, that does not hamper my use of the same ideas.

Because of this feature, intellectual property is quite different in law, and in economics, than other kinds of property. Ideally, once an idea is produced, it should be distributed freely to everybody. The marginal cost is zero, it is nonrival, so society is best off if everyone gets to use new ideas immediately. Economic growth is the spread of better ideas, and the faster the better. Period.

Wednesday, April 11, 2018

Why not taxes?

Reaction to the Washington Post oped (blog post, pdf) on debt  has been sure and swift. We suspected we might get criticized by Republicans for complaining about deficits are a problem.  Instead, the attack came from the left.  Justin Fox hit first, followed by a joint oped by Martin  Baily, Jason Furman, Alan Krueger, Laura Tyson and Janet Yellen. It's almost an official response from the Democratic economic establishment.

Their bottom line, really, is that entitlements and deficits are not a problem. They put the blame pretty much entirely on the recently enacted corporate tax cut.   (I'm simplifying a bit. As did they, a lot.)

By contrast, we focused on entitlement spending -- Social Security, Medicare, Medicaid, VA, pensions, and social programs -- as the central budget problem, and entitlement reform (not "cut") together with a strong focus on economic growth as the best answer. Our warning was that interest costs could rise sharply and unexpectedly and really bring down the party.

Well, deficit equals spending minus tax revenue, so why not just raise taxes to solve the budget problem?

First, let's get a handle on the size and source of the problem. 

I. Roughly speaking the long term deficit gap is 5 rising to 10 percentage points of GDP. And the big change is entitlements -- social security, medicare, medicaid, pensions. 

For example, even Fox's graph shows social security spending rising from 11% of payroll in 2006 and asymptoting at 18%.

The most recent 2017 CBO long-term budget outlook is quite clear. Long before the tax cut that so upsets our critics was even a glimmer in the President's eye, they were warning of budget problems ahead:
If current laws generally remained unchanged, the Congressional Budget Office projects, ..debt...would reach 150 percent of GDP in 2047. The prospect of such large and growing debt poses substantial risks for the nation....
Why Are Projected Deficits Rising?
In CBO’s projections, deficits rise over the next three decades—from 2.9 percent of GDP in 2017 to 9.8 percent in 2047—because spending growth is projected to outpace growth in revenues (see figure below). In particular, spending as a share of GDP increases for Social Security, the major health care programs (primarily Medicare), and interest on the government’s debt.
The CBO gives us this nice graphs to make the point:



Another CBO's graph follows. Top graph -- where is the spending increase? Social security, health, and interest. Not "other noninterest spending."

(In the bottom graph you see a rosy forecast that individual income taxes will rise a few percent of GDP to help pay for this. Don't be so sure. This comes from inflation pushing us into higher tax brackets and assuming congress won't do anything about it. Notice also how small corporate taxes are in the first place.)


The more recent CBO budget and economic outlook is equally clear: The near term problem is 5 percentage points of GDP:
CBO estimates that the 2018 deficit will total $804 billion....[GDP is $20 Trillion, so that's 4% of GDP]  ... In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022... Deficits remain at 5.1 percent between 2022 and 2025 ... Over the 2021–2028 period, projected deficits average 4.9 percent of GDP..
Then, things get worse,
In CBO’s projections, outlays for the next three years remain near 21 percent of GDP, which is higher than their average of 20.3 percent over the past 50 years. After that, outlays grow more quickly than the economy does, reaching 23.3 percent of GDP ... by 2028. 
That increase reflects significant growth in mandatory spending—mainly because the aging of the population and rising health care costs per beneficiary are projected to increase spending for Social Security and Medicare, among other programs. It also reflects significant growth in interest costs, which are projected to grow more quickly than any other major component of the budget, the result of rising interest rates and mounting debt. ... 
And that's only 2028.

You see the problem in our critic's complaint:
"The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending. This year, revenue is expected to fall below 17 percent of gross domestic product." 
Let us take the estimate that the recent tax cut cost $1.5 trillion over 10 years, i.e. $150 billion per year or 0.75% of GDP.  Compared to the $800 billion current deficit it's small potatoes. Compared to the 5 percent to 10 percent of GDP we need to find in the sock drawer, it's peanuts.   (Compared to the $10 trillion or more racked up in the last 10 years it's not huge either!)

[Update: Thanks to commenters, I now notice the "had been expected." OK, we expected 4% of GDP deficits, and then they passed a tax cut and now it's 5% of GDP. Sure. On the day that the tax cut was passed, the entire increase in the deficit was due to the tax cut. But our article, and the economy, is about the overall level of the deficit. The problem is what had been expected, not the recent minor change!]

Here is what the CBO has to say about it: 
For the next few years, revenues hover near their 2018 level of 16.6 percent of GDP in CBO’s projections. Then they rise steadily, reaching 17.5 percent of GDP by 2025. At the end of that year, many provisions of the 2017 tax act expire, causing receipts to rise sharply—to 18.1 percent of GDP in 2026 and 18.5 percent in 2027 and 2028. They have averaged 17.4 percent of GDP over the past 50 years.
17, maybe 18. We're waddling around in the 1% range, when the problem is in the 10 percent range. The long run budget problem has essentially nothing to do with the Trump tax cut. It has been brewing under Bush, Obama, and Trump. It fundamentally comes from growth in entitlements an order of magnitude larger. 

It is simply not true that "The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending."

To call us "dishonest" -- to call George Shultz "dishonest," in the printed pages of the Washington Post -- for merely repeating what's been in every CBO long term budget forecast for the last two decades really is a new low for economists of this stature. Is Krugmanism infectious?

Put another way, US government debt is about $20 trillion. Various estimates of the entitlement "debt," how much the government has promised more than its revenues, start at $70 trillion and go up in to the hundreds.

To be clear, I agree with the critic's complaint about the tax cut.
"The right way to do reform was to follow the model of the bipartisan tax reform of 1986, when rates were lowered while deductions were eliminated."
Yes! As in many previous blog posts, I am very sad that the chance to do a big 1986 seems to have passed. A large, revenue neutral, distribution neutral, savage cleaning and simplification of the tax code would have been great. There are some elements in the current one -- the lower marginal corporate rate is nice, and there is some capping of deductions, which is why it was a "good first step." But it fell short of my dreams too in many ways.

If only these immensely influential authors had been clamoring for their friends in the Resistance to join forces and pass such a law, rather than (Larry and Jason in particular) spend the whole time arguing that corporate tax cuts just help the rich, perhaps it might have happened. Having to do the whole thing under reconciliation put a lot of limits on what the Republicans could accomplish.

All that aside though, we're still talking about 0.75% of GDP cut compared to a 5%-10% of GDP problem. The long run deficit problem does not come from this tax cut.

II OK, so why not just tax the rich to pay for entitlements? 

I hope I have sufficiently dismissed the main line of this particular criticism -- that deficits are all due to the Trump tax cut and all we have to do is put corporate rates back to 35% and all will be well.

On to the larger question, echoed by many commenters on our piece. OK, social security and health are expensive. Let's just tax the rich to pay for it. Like Europe does, so many say.

I do think that roughly speaking we could pay for American social programs with European taxes. That is, 40% payroll taxes rather than our less than 20%; 50% income taxes, starting at very low levels; 20% VAT; various additional taxes like 100% vehicle taxes and gas that costs 3 times ours.

I don't think we can pay for European social programs with European taxes, because Europe can't do it. Their debt/GDP ratios are similar to ours. And their lower growth rates both are the result of this system and compound the problem. Many European countries are responding exactly as we suggest, with deep reforms to their social programs -- less state-paid health insurance, more stringent eligibility requirements and so on.

But that's the option: heavy middle class taxes for middle class benefits, at the cost of substantially lower growth, which itself then drives the needed tax rates up further.

America in fact already has a more progressive tax system than pretty much any other country. Making it more progressive would increase economic distortions dramatically.

A key principle here is that the overall marginal tax rate matters.  There is a tendency, especially on the left, to quote only the top Federal marginal rate of about 40%, and to say therefore that high income Americans pays less taxes than most of Europe. But that argument forgets we also pay state and sometimes local taxes.

The top federal rate is about 40%. In California, we add 13% state income tax, and with no deductibility we're up to 53% right there. But what matters is every wedge between what you produce for your employer and the value of what you get to consume. So we have to add the 7.5% sales tax, so we're up to 60.5% already.

But we're not done.  The Federal corporate tax is now 21%, and California adds 8.84%, so roughly 29% combined. Someone is paying that. If, like sales tax it comes out of higher prices, then add it to the sales tax. Those on the left say no, corporate taxes are all paid by rich people, which is why they were against lowering them. OK, then they contribute fully to the high-income marginal rate.

What about property tax? The main thing people do with a raise in California is to buy a bigger house. Then they pay 1% property tax. As a rough idea, suppose you pay 30% of your income on housing and the price is 20 times the annual cost (typical price/rent ratio). Then you are paying 6% of your income in property taxes. Add 6 percentage points.

I'm not done. All distortions matter. In much of  Europe they charge taxes and then provide people health insurance. We have a cross subsidy scheme, in which you overpay to subsidize others. It's the same as a tax, except much less efficient.  In terms of economic damage, and the overall marginal rate, it should be included. If you live in a condo, whose developer was forced to provide "affordable housing" units, you overpaid just like a tax and a transfer. And so on. I won't try to add these in, but all distortions count.

In sum, we're at a pretty high marginal tax rate already. The notion that we can just blithely raise another 10% of GDP from "the rich" alone without large economic damage does not work.  This isn't a new observation. Just about every study of how to pay for entitlements comes to the same conclusion.

Again, my argument is not about sympathy for the rich. It is a simple cause and effect argument. Marginal tax rates a lot above 70% are going to really damage the economy and not bring in the huge revenue we need.

Bottom line: Paying for the current entitlements entirely by taxes would involve a big tax hike on middle income Americans. 

III Answers

The most important answer is economic growth. 30 years of 3% growth rather than 2% growth gives you 35% more GDP, and thus 35% more tax revenue. If federal revenues are 20% of GDP, that's 7%
of the previous GDP right there.  Deregulation and tax reform -- get on with the lower marginal rates and simplification that we agree on -- are important.

(The CBO also writes,
In CBO’s projections, the effects of the 2017 tax act on incentives to work, save, and invest raise real potential GDP throughout the 2018–2028 period....
The largest effects on GDP over the decade stem from the tax act. In CBO’s projections, it boosts the level of real GDP by an average of 0.7 percent and nonfarm payroll employment by an average of 1.1 million jobs over the 2018–2028 period. During those years, the act also raises the level of real gross national product (GNP) by an annual average of about $470 per person in 2018 dollars.
This is not a terrible result!)

Our oped was clear to say social program "reform" not just "cut." Little things like changing indexing and retirement ages make a big difference over 30 years. We argue for reducing the growth and expansion of entitlements, not "cut."  Removing some of the very high work disincentives would help people get off some programs. Europe is facing this too, and many countries are a good deal more stringent about qualification than we are.

Our critics say that to point out America cannot pay for the entitlements we have currently promised "dehumanizes the value of these programs to millions of Americans." No. Failing to reform entitlements now and gently will lead to chaotic cuts in the future, on programs that people depend on. If we're going to throw around accusations of heartlessness, denying the problem is the heartless approach.