After Dodd-Frank

(Youtube link) A talk given at the Mercatus Center / CATO conference "After Dodd-Frank: The Future of Financial Markets." (The link has videos of the whole conference.) The talk is taken from the paper "Towards a Run-Free Financial System," which answers many objections you may have to claims in the talk. (Yes, I have plugged it before on the blog and will likely do again.)

The more I read about it, the more I think it's important to define what is not a problem, and can be left alone. If we have to solve housing subsidies, Fannie and Freddie, global imbalances, Wall Street greed, compensation, inequality, savings gluts, predatory lending, financial utilities, bankruptcy law, behavioral biases of equity managers, living wills, stress tests, capital ratios, Basel regulation, macroprudential bubble-detection and pricking, complexity of derivatives, exchange vs. otc trading, and so on and so on just to save ourselves from the next crisis, we might as well give up now.

Liquidity and IOR

Re: the big balance sheet and how it improves financial stability.

Rodney Garratt, Antoine Martin, and James McAndrews at the New York Fed have a very nice post, Turnover in Fedwire Funds Has Dropped Considerably since the Crisis, but It’s Okay.

Before the crisis, banks held about $50 billion of reserves at the Fed. That's not a lot of money. When banks want to pay each other -- say you write a check to me, so my bank has to get money from your bank -- they do it by transferring reserves through the Fedwire.  So, that's why banks keep some reserves there.

But $50 billion is tiny compared to $10 trillion of M2, and banks use reserves to clear financial transactions too. A huge amount must flow by passing around these tiny reserves. How did banks do it? What happens if bank B says to bank A, "send us $10 million" and bank A didn't have $10 million left at that second in reserves?

Answer: "intraday overdrafts." The Fed would lend bank A the $10 million -- just flip a switch and put $10 million in their reserve account, and call the loan an asset corresponding to this liability. A then pays B, and works hard to make sure that it collects $10 million from C and D by the end of the day.

Source: Rodney Garratt, Antoine Martin, and James McAndrews at the New York Federal Reserve

Krugman on housing

I generally don't read Paul Krugman -- bad for the blood pressure -- and I even less often respond -- don't dignify the insults or feed the trolls. But I took a long plane flight yesterday, and the Times was all I had to read, so I stumbled across his column on housing.

After getting through the customary political barbs at Republicans (Rick Perry in this case), and snarky insults ("the habit economists pushing this line have of getting their facts wrong"), I found something almost sensible.

People, especially "middle class" people,  are moving away from New York and to California, and to Texas and Georgia. Nominal wages in Texas and Georgia are not higher. So why do they move? Answer: Real wages are a lot higher, because the cost of living is so much less. It's practically like moving to a foreign country (in  many ways!). You are earning $100,000 in the un-hip part of Brooklyn, they offer you 80,000 zingbats to move to Truckgunistan. Is it a good deal? Well, you get two dollars per zingbat, so sure!

IOR caused the recession!

Apparently saying something nice about the Fed last week stepped over some bright line somewhere.
Lois Woodhill, writing at Forbes.com, wrote one of the most unintentionally hilarious rebukes here.

Source: Louis Woodhill at Forbes.com

The above chart

...shows what happened the last time the Fed raised the IOR rate [to 0.25%] (remember, it was zero for 95 years). 

The plunge in velocity overwhelmed the Fed’s frantic money creation during the period immediately after it started paying IOR.  NGDP tanked, taking RGDP and employment with it. 

Look, something caused the economic collapse of 2008-2009.  Given the evidence, IOR looks a lot like a man caught at a murder scene with a smoking gun in his hand.

Interesting.  Interest on reserves caused the recession!

Musgrave on 100% reserves

In a comment on an earlier post, Ralph Musgrave pointed to his interesting new paper on 100% reserve banking.

I haven't read the paper yet, but I love the Table of contents, reproduced partially below.

The name "narrow Banking" or "full reserve banking" needs improvement. It's really very wide banking -- so long as the banking is funded by equity or long-term debt. To say "narrow" is almost a fallacy in itself, and perpetuates the fallacy that bank lending will dry up. Maybe "Equity financed banking" or "full reserve deposit taking" would be better. Can anyone think of a name that is both sexy and accurate?

Musgrave's Fourty-four fallacies regarding full reserves:

Section 2: Flawed arguments against FR. .............................. 36
1. FR limits the availability of credit? ................................................................. 36
2. Central bank money is not debt free?............................................................ 38
3. Bank capital is expensive for tax reasons?.................................................... 38

A Few Things the Fed Has Done Right

WSJ Oped, here.

As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions  ...

I like the large balance sheet and market interest on reserves. I just want them to be permanent, not additional tools for Fed discretionary policy.

I'll post the whole thing in 30 days.

The Oped builds on a new paper, Monetary Policy with Interest on Reserves, and on Toward a Run-Free Financial System. In the latter, I advance the idea that the Fed and Treasury should first offer interest-paying money, and then stamp out private substitutes, just as the US first offered banknotes and then stamped out run-prone substitutes in the 19th century. Interest on reserves, a big balance sheet,  and opening reserves to all are a first step.

Lazear on Labor

Ed Lazear has a very nice short column, Job Turnover Data Show Lots Of Churning, Little Job Creation on Investor's Business Daily.

Modern labor economists see employment and unemployment as a search and matching process with a lot of churn. The popular impression, echoed in most media discussion, is that there is a fixed number of jobs, and people just wait around for more jobs to be "created." That's what it may feel like to an individual, but that's not how the economy works. Lazear's column puts in one very short space some of the better ways to think about unemployment.

The central fact of labor markets is huge churn, not a fixed number of lifelong jobs:

CON at it again.

An intriguing news item, University of Chicago's Plan to Add 43 Hospital Beds Quashed by the State by Sam Cholke about the University of Chicago's attempt to expand its hospital. And one more of today's costs-of-regulations anectodes.

In researching "After the ACA" about supply-side restrictions in medicine and health insurance, I became aware of CON ("certificate of need") laws. Yes, to expand or build a new hospital, in many states, you need state approval, and those proceedings are predictably hijacked politically. For once, they came up with an unintentionally appropriate acronym.

Immigration reading

Does Economics 101 Apply to Immigration? by Robert VerBruggen, a review of George Borjas' new book Immigration Economics.

The question is central to the immigration debate. If new people come in, do they depress the wages of competing workers here, and if so how much? "But it's 'suprisingly difficult' to demonstrate that this actually happens, according to the famed Harvard labor economist George Borjas. Very good review, need to read the book.

Of course, protectionism 101 still applies. If cheap Chinese sneakers come in, do they depress the profits of competing sneaker producers here? Yes. Does that mean we wall off trade? No, but neither ignore its distributional consequences.

FDA and the costs of regulation

The Wall Street Journal has had two recent articles on the FDA, "Why your phone isn't as smart as it could be" by Scott Gottlieb and Coleen Klasmeier on how FDA regulation is stopping health apps on your iphone, and Alex Tabarrok's review of "Innovation breakdown," the sad story of MelaFind, a device that takes pictures of your skin and a computer then flags potential cancers. The FAA's ban on commercial use of drones is another good current example.

One of our constant debates is how much regulation or the threat of regulation is slowing economic growth.  Over the weekend, for example, Paul Krugman, finding the New York Times itself too soft on libertarians,

Anat Admati profile in the New York Times

Source: New York Times

When she talks, banks shudder. A very nice profile of Anat Admati by Binyamin Applebaum in the New York Times.

The article got most of the big points right. Banks don't "hold" capital, they issue it.

“The industry has benefited from, and sometimes encouraged, public confusion. Banks are often described as “holding” capital, and capital is often described as a cushion or a rainy-day fund. “Every dollar of capital is one less dollar working in the economy,” the Financial Services Roundtable, a trade association representing big banks and financial firms, said in 2011. But capital, like debt, is just a kind of funding. It does the same work as borrowed money. The special value of capital is that companies are under no obligation to repay their shareholders, whereas a company that cannot repay its creditors is out of business."

Look for the usage "banks hold capital" in the vast majority of financial press, including newspapers that should know better, for a sense of how pervasive this fallacy is.

The article mentioned the argument that equity costs more than debt, got right that much of that is due to debt subsidies and the difference between private and social cost:

S&P economists and inequality

Neil Irwin at the New York Times writes interesting coverage of a report titled "How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide" by S&P economists.

The article starts with interesting comments about business economists

...you have to know a little bit about the many tribes within the world of economics. There are the academic economists...many labor in the halls of academia for decades writing carefully vetted articles for academic journals that are rigorous as can be but are read by, to a first approximation, no one. 

Ouch!

QE and interest rates

Source: Wall Street Journal

In an August 3 article, the Wall Street Journal made the graph at left.

The US and UK have done a lot of "Quantitative easing," buying up long-term government bonds and mortgage-backed securities, to the end of driving down long-term interest rates. Europe, not so much, and the WSJ article quotes lots of people imploring the ECB to get on the bandwagon.

It's a curious experiment, as standard theory makes a pretty clear prediction about its effects: zero.  OK, then we dream up "frictions," and "segmentation," and "price pressure" or other stories. Empirical work seems to show that the announcement of QE lowers rates a bit.  But those theories only give transitory effects, and there is no correlation between actual purchases and interest rates. (p.2 here for example.)

So back to the graph.

Renewing Prosperity, The Op-Ed

For its 125th anniversary issue, the WSJ asked "If you could propose one change in American policy, society or culture to revive prosperity and self-confidence, what would it be and why?" Oh, and you have 250 words. I asked my son what to do. He answered quickly, "wish for more wishes." That's pretty much what I did.

My answer, along with some great other essays here at the WSJ. (WSJ asks us to hold off reposting for 30 days, which is why it's here now.)

Limit Government and Restore the Rule of Law

America doesn't need big new economic ideas to get going again. We need to address the hundreds of little common-sense economic problems that everyone agrees need to be fixed. Achieving that goal requires the revival of an old political idea: limited government and the rule of law.

Our tax code is a mess. The budget is a mess. Immigration is a mess. Energy policy is a mess. Much law is a mess. The schools are awful. Boondoggles abound. We still pay farmers not to grow crops. Social programs make work unproductive for many. ObamaCare and Dodd-Frank are monstrous messes. These are self-inflicted wounds, not external problems.

Why are we so stuck? To blame "gridlock," "partisanship" or "obstructionism" for political immobility is as pointless as blaming "greed" for economic problems.

Washington is stuck because that serves its interests. Long laws and vague regulations amount to arbitrary power. The administration uses this power to buy off allies and to silence opponents. Big businesses, public-employee unions and the well-connected get subsidies and protection, in return for political support. And silence: No insurance company will speak out against ObamaCare or the Department of Health and Human Services. No bank will speak out against Dodd-Frank or the Securities and Exchange Commission. Agencies from the Environmental Protection Agency to the Internal Revenue Service wait in the wings to punish the unwary.

This is crony capitalism, far worse than bureaucratic socialism in many ways, and far more effective for generating money and political power. But it suffocates innovation and competition, the wellsprings of growth.

Not just our robust economy, but 250 years of hard-won liberty are at stake. Yes, courts, media and a few brave politicians can fight it. But in the end, only an outraged electorate will bring change—and growth.

Macro debates, the oped

This is a a Wall Street Journal Op-Ed, on supply vs, demand in understanding slow growth. WSJ asks that I don't re-post the oped for a month; a month has passed so here it is for those of you who don't subscribe to WSJ.

The underlying paper is The New Keynesian Liquidity Trap, for those wanting more substance to some of the claims about New Keynesian models.

They didn't want the graph, but I think it illustrates the point well.

The Op-Ed, [with a few cuts restored and one typo fixed]:

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Sclerotic growth trumps every other economic problem. Without strong growth, our children and grandchildren will not see the great rise in health and living standards that we enjoy relative to our parents and grandparents. Without growth, our government's already questionable ability to pay for health care, retirement and its debt evaporate. Without growth, the lot of the unfortunate will not improve. Without growth, U.S. military strength and our influence abroad must fade.

Hedge Funds

I recently stumbled across the FT Alphaville collection on hedge fund performance.

The latest, "The hare gets rich while you don't: back the passive tortoise" reviews a Nomura report covering the performance of "alternative investments," private equity and hedge funds. (The report is here, alas behind the FT's very confusing paywall.) A while ago I put together a class and talk covering hedge fund literature, but haven't updated it in a few years so reviews with updates are particularly interesting.

The fact that hedge funds and private equity have a lot of beta -- often hidden by infrequent or inaccurate marking to market -- remains true:

Work and Jail

I have run in to some interesting recent readings on the nexus between work, or the lack thereof, jail and drugs.  In case you didn't know, the numbers are staggering.

The table below, from The Prison Boom and the Lack of Black Progress since Smith and Welch by Derek Neal and Armin Rick, gives the fraction of black male high school dropouts employed, and below that the fraction that are institutionalized -- mostly in jail.

So, bottom left, in the last census, 19.2% of 20-24 year olds were employed, and 26.4 (!) percent were in jail. Read up, and it was not always thus. Of the cohort born in the 1930s, at the same age, 68% were employed and 6.7% were in jail -- in a society and criminal justice system that was, whatever our current faults, much more overtly racist. The numbers for older men are just as shocking if you haven't see these before.