Consumer financial protection, 1984

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

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

Consumer financial protection, 1840

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

It doesn't always work out that way.

A brief parable of over-differencing

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

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

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

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

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

547 pages

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

Demographics and stock prices

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

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

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

Romer on Regulation

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

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

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

New Keynesian Stimulus

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

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

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

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

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

Stimulus and Etiquette

The stimulus wars are heating up again.

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

Some response seems called for.

Romney's 15%

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

Powell's secrets

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

DeLong on Friedmans and Freedoms

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

News flash: Bernanke not clairvoyant

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

What zero bound?

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

Source: Wall Street Journal

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

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

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

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

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

Hungarian Outrage

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

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

It has some good reminders for the US as well.

The World's Biggest Hedge Fund

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

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

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

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

Is this good or bad?

Goolsbee on budgets

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

The last paragraph caught my eye:

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

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

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

Should Greece Devalue?

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

Defenders [of devaluation] think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budget and economic troubles. Why do economists think Greek politicians are so much wiser? 

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

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

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

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

The VAT, a libertarian dilemma

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

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

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

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

Three kinds of regulation

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

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