Trade War 1914

The analogy between our looming trade war and August 1914, when events quickly spun out of control, led to this opinion essay at thehill.com. It brings together some themes from recent blog posts, so faithful readers may find some repetition. For reasons of space, a desire not to personalize things too much, and not to strain real history vs. the the superficial stories we retell,  I didn't overdo the 1914 analogy. But it's easy enough to do if you want to. An impulsive leader, sensitive to personal sleights, started something that spiraled out of control. The idea that opponents will quickly surrender, rather than stiffen their resolve, has proved wrong over and over again in history.

The trade war to end trade wars will end badly

104 years ago this August, the war to end wars broke out. It was a war that nobody wanted. The world stumbled in to it almost by accident, and then could not get out. “Wars are easy to win,” leaders thought. “We’ll be in Paris (or Berlin) by fall.”  They were equally wrong, and equally befuddled once the trenches filled with bodies.

This August, the trade war to end tariffs looms, and the world seems to be stumbling towards an economic calamity that nobody wants, propelled by similar entanglements.

Single payer sympathy?

A July 30 2018 Op-Ed in the Wall Street Journal, titled "The tax and spend health care solution"

Why is paying for health care such a mess in America? Why is it so hard to fix? Cross-subsidies are the original sin. The government wants to subsidize health care for poor people, chronically sick people, and people who have money but choose to spend less of it on health care than officials find sufficient. These are worthy goals, easily achieved in a completely free-market system by raising taxes and then subsidizing health care or insurance, at market prices, for people the government wishes to help. 

But lawmakers do not want to be seen taxing and spending, so they hide transfers in cross-subsidies. They require emergency rooms to treat everyone who comes along, and then hospitals must overcharge everybody else. Medicare and Medicaid do not pay the full amount their services cost. Hospitals then overcharge private insurance and the few remaining cash customers. 

Overcharging paying customers and providing free care in an emergency room is economically equivalent to a tax on emergency-room services that funds subsidies for others. But the effective tax and expenditure of a forced cross-subsidy do not show up on the federal budget. 

Over the long term, cross-subsidies are far more inefficient than forthright taxing and spending. If the hospital is going to overcharge private insurance and paying customers to cross-subsidize the poor, the uninsured, Medicare, Medicaid and, increasingly, victims of limited exchange policies, then the hospital must be protected from competition. If competitors can come in and offer services to the paying customers, the scheme unravels. 

No competition means no pressure to innovate for better service and lower costs. .....

...

As usual, I have to wait 30 days to post the whole thing.  It synthesizes some of my earlier blog posts (here here here)  on how cross subsidies are worse than straightforward, on budget, taxing and spending.

Let me here admit to one of the implications of this view. Single payer might not be so bad -- it might not be as bad as the current Medicare, Medicaid, Obamacare, VA, etc. mess.

But before you quote that, let's be careful to define what we mean by "single payer," which has become a mantra and litmus test on the left. There is a huge difference between "there is a single payer that everyone can use," and "there is a single payer that everyone must use."

Most on the left promise the former and mean the latter. Not only is there some sort of single easy to access health care and insurance scheme for poor or unfortunate people, but you and I are forbidden to escape it, to have private doctors, private hospitals, or private insurance outside the scheme.   Doctors are forbidden to have private cash paying customers. That truly is a nightmare, and it will mean the allocation of good medical care by connections and bribes.

But a single provider or payer than anyone in trouble can use, supported by taxes, not cross-subsidized by restrictions on your and my health care -- not underpaying in a private system and forcing that system to overcharge others -- while allowing a vibrant completely competitive free market in private health care on top of that, is not such a terrible idea, and follows from my Op-Ed. A single bureaucracy that hands out vouchers, pays full market costs, or pays partially but allows doctors to charge whatever they want on top of that would work. A VA like system of public hospitals and clinics would work too.  Like public schools, or public restrooms, you can use them, but you don't have to; you're free to spend your money on better options if you like, and people are free to start businesses to serve you. And no cross-subisides.

Whether we restrict provision with income and other tests, and thus introduce another marginal disincentive to work, or give everyone access and count on most working people to choose a better product, I leave for another day. It would always be an inefficient bureaucratic problem, but it might not be the nightmare of anti-competitive inefficiency of the current system.

The free market describes well how your and my health care and insurance should work. It does not offer nearly so clear advice on how the government should manage the finances and bureaucracy that provide subsidies (if we want to provide them).  There are always tradeoffs, generosity vs. moral hazard and disincentives. Economics is crucial to understanding those tradeoffs, of course, but the answer will always be a muddy middle of tradeoffs. I have offered that taxing and spending -- on budget and appropriated -- to provide those subsidies may be better than the current mandated cross subsidies. We already have a "single payer" -- the federal government. The argument that a  single point of entry, a single payer, or a single provider, may be more rational and cost effective than the current system  for the purpose of providing subsidized care is not as crazy as it sounds -- if it allows a free the market for the majority of Americans who own cars, houses, TVs and cell phones and can pay for better services in that free market.

"Single payer" also usually means "single price-setter." It means a gargantuan Federal bureaucracy that will somehow produce health care cost savings by simply decreeing that doctors and hospitals be paid less. Good luck with that.

Both left and right forget that "negotiation" means only you pay less and somebody else pays more. We can't all pay less by negotiation. Price controls mean rationing. Period. This is the heart of current "single payer" proposals, and they are doomed.

My "single payer" is just that, a "payer," operating in a completely free market.

Still, when a politician endorses "single payer," ask "does that mean we all can use a single payer? Or does that mean we all must use a single payer?"

Trade war off?

Events move quickly in the Trump era. Since my last post, President Trump met with European Commission President Jean-Claude Juncker and announced a cease-fire with Europe.  A correspondent sends this link to Marc Thiessen at Fox news on the subject

it appears Trump is being proved right. On Wednesday, he and European Commission President Jean-Claude Juncker announced a cease-fire in their trade war and promised to seek the complete elimination of most trade barriers between the United States and the European Union. "We agreed today ... to work together toward zero tariffs, zero non-tariff barriers, and zero subsidies on non-auto industrial goods," declared the two leaders in a joint statement.   

.... contrary to what his critics allege, Trump is not a protectionist; rather, he is using tariffs as a tool to advance a radical free-trade agenda.

... during the G-7 summit he made a sweeping proposal. "I said, 'I have an idea, everybody. I'll guarantee you we'll do it immediately. Nobody pay any more tax, everybody take down your barriers. No barriers, no tax. Everybody, are you all set?' ...

Now Trump's hard-line trade strategy is being vindicated. Not only is the E.U. negotiating zero tariffs, but also it agreed to immediately buy more American soybeans -- which helps Trump in his trade battle with China.

If Trump succeeds in using trade wars to bring down European and Chinese trade barriers, he may end up being one of the greatest free-trade presidents in history.

The question always remains with our President's dramatic moves. Crazy like a fox or just plain crazy?  To his credit, it helps if your opponents think the latter.

Could this trade war really be in the service of a completely free trade agenda -- either very well hidden, or newly discovered? There is nothing I would like to see more than a pure free trade world, and it is heartening to see this president or any president come close to endorsing such.

"Non-auto industrial goods" is already a big qualifier. US' 25% import tax on pickup trucks remains, and Europe's auto protection as well. Europe's big barriers against agricultural goods remain, along with the US' too. (Sugar quotas on and off since the 1790s, lots of Mexican produce barred even under Nafata.) Services, more important in the modern world than industrial goods,  are off the table. So pure free trade this is not.

"it [europe] agreed to immediately buy more American soybeans -- which helps Trump in his trade battle with China." Free trade this is not. In a free trade world, European governments do not stop private European people and companies from buying US soybeans. In a free trade world, government ministers do not agree to buy more American soybeans! That's government run trade 101. Especially to gang up on a third party.

Valentina Pop and Vivian Salama at the Wall Street Journal add some reporting

Mr. Juncker stuck closely to the negotiating mandate handed to him by leaders of big EU countries including Germany, France and the Netherlands. Germany, which is heavily dependent on exports, was from the onset open to a trade arrangement, including abolishing EU tariffs on U.S. car imports. France, meanwhile, was vehemently opposed to opening EU agricultural markets.

Mr. Juncker told Mr. Trump and Mr. Lighthizer that any talk of including agriculture would kill prospects of a deal. He countered with a threat to drag public procurement into negotiations, which would question the Buy American Act, a nonstarter for the U.S. side.

Well so much for unfettered free trade. Plus, as widely reported, this was a cease fire. There is no schedule for talks or any other implementation of the free trade niravna.

"We can do stupid too" said Mr. Junckers, and he is right. This is stupid. We can shoot holes in the bottom of the boat to try to get you to stop shooting holes in the bottom of the boat. But if this is going to work, it had better work darn fast before the boat sinks.

Does President Trump really believe in a free trade world? Is this where it is all heading? In my last post I questioned the lack of a public goal to all this. Only two days ago -- yes, an eternity in Trump time, but fairly recent for the rest of us, the President tweeted

$817 seems to represent the overall trade "deficit" (I hate that word!) and Mr. Trump has consistently labeled trade deficits a "loss" for the US. (No, just as your trade deficit with the grocery store is not a loss -- you get the food!) If his hope is that the point and success of completely free trade is to eliminate trade "deficits," Mr. Trump will be sorely disappointed, as will any of his supporters who view this as a goal.

Completely free trade will open up many slowly dying industries to quick death from international competition. It will open up many new industries to tremendous growth. But is Mr. Trump really prepared to accept the former? In his tour through steel country, he did not say, "In six months I hope to see you all unemployed and this mill shut down again. But the opportunities for the country in software development, banking services, and intellectual property are so huge, I want you to support it."

The big question is, when does this stop? If it stops when we have global free trade, great. If we are going to keep plowing forward with tariffs, managed trade, countervailing subsidies, and so on until the trade "deficit" is eliminated, not so good.

OK, skepticism aside, yes he has twice said that the goal is totally free trade. I suggest the rest of the world call the bluff, if it is one, or give him what he wants, if not, immediately!

Tariffs, quotas, managed trade, arbitrary waivers, will damage the economy and our political system quickly. If this is going to work, it had better work fast.

Trade War

I am encouraged by the reported Senate reaction (Politico) to the latest salvo in the trade war, the agriculture department's announcement to ramp up Roosevelt-era farm subsidies to offset the Administration's tariffs.

“Taxpayers are going to be asked to initial checks to farmers in lieu of having a trade policy that actually opens and expands more markets. There isn’t anything about this that anybody should like,” said Sen. John Thune of South Dakota, the No. 3 GOP leader....

You put people in the poorhouse and provide them aid. What you need to do is not put them in the poorhouse,” Corker said 

These views are good, but not really in my mind the largest danger. The closest is Sen. Ron Johnson:

“This is becoming more and more like a Soviet type of economy here: Commissars deciding who’s going to be granted waivers, commissars in the administration figuring out how they’re going to sprinkle around benefits,” said Sen. Ron Johnson (R-Wis.). ...”

It's not really Soviet, which was more do what you're told or go to Siberia. It's a darker system, which leads to crony capitalism. 

Everyone depends on the whim of the Administration. Who gets tariff protection? On whim. But then you can apply for a waiver. Who gets those, on what basis? Now you can get subsidies. Who gets the subsidies? There is no law, no rule, no basis for any of this. If you think you deserve a waiver, on what basis do you sue to get one? 

Well, it sure can't hurt not to be an outspoken critic of the administration when the tariffs, waivers, and subsidies are being handed out on whim. 

This is a bipartisan danger. I was critical of the ACA (Obamacare) since so many businesses were asking for and getting waivers. I was critical of the Dodd Frank act since so much regulation and enforcement is discretionary. Keep your mouth shut and support the administration is good advice in both cases. And to my mind, our drift to an economy in which every successful business needs a special waiver or dispensation from the government, granted at the government's pleasure or displeasure,  is our greatest danger. 

I'm even more delighted to see signs of Congress waking up

... a number of senators have been itching to tie the president’s hands from making unilateral tariff policy with legislation that would require Congress to approve of unilateral tariffs that are imposed with the justification of national security.

Yes, but that's only the beginning. Tariffs are a tax. Why does the President have unilateral power to impose a tax? The president can't change the income tax code (except for some interpretation issues. Index capital gains for inflation now!)

The answer is, because the Congress handed him that power. Congress likes to pass laws that make it look protectionist, and then count on the fact that no sane Administration would ever enforce them.

The regular trade law basically says that the Administration should impose tariffs if any industry is hurt. That's basically any industry that has any imports, i.e. all of them. We have counted for decades on no administration being nutty enough to actually do that.

The national security provisions under which the Trump administration is acting are even vaguer.

By now, both parties ought to be sick of the imperial presidency. Take back the power to impose tariffs. Or at least write a reasonable statute: that tariffs and quotas may only be imposed if consumers are harmed.

If national security is an issue, then write that the defense department must ask for it and pay for it. Do we need steel mills so we can re-fight WWII? If so, put subsidized steel mills on the defense budget. If defense prefers to use the money for a new aircraft carrier rather than a steel mill, well, that's their choice.

We are told that the trade war is all a game on the way to freer trade. I am dubious. From WSJ coverage,

What’s the strategy, what’s the end game here? At what point do we start seeing things move out of the chaotic state they are in now and to where we actually see new trade agreements?” asked Sen. Mike Rounds (R., S.D.).

Mr. Trump, addressing a gathering of veterans groups on Tuesday, urged patience on trade, despite concerns raised by critics: “Just stick with us,” he said. “It’s all working out.”

Well, what is the end game? If it is a world of zero tariffs -- a suggestion the G7 should have taken and run with -- fine, but say so. If it is for China to reform intellectual property treatment, fine, say so. You cannot expect a negotiating adversary to move unless that adversary understands that if you do X, the problem really will be solved. If the goal posts always shift, they have no reason to budge.

I fear the goal is a bilateral trade surplus with every nation. That cannot happen without a massive change in our saving rate and federal deficit. In the meantime, if you impose a lot of tariffs on a country, its exchange rate depreciates so that the overall amount of trade is exactly the same. As is already happening with China, and now currency manipulation charges are back in vogue.*

Wars are hard to win, and they are only won if you have a clear objective, and know to stop when you reach the objective.

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* Update: A blog reader asked for an explanation.

You run a trade deficit with the grocery store. They sell you more food than you sell them. You run a surplus with your employer. You sell him or her more services than they sell you. Bilateral deficits are not a bad thing! If your garden is anything like mine, growing your own is a bad idea.

If you earn more from your employer than you spend at the store, then you are saving money. You run a net trade surplus with the world, and save it. You are accumulating financial assets. If you run a net trade deficit with the world, you are dissaving or borrowing.

So, we have the ironclad law. Savings - Investment = Net Exports. If you want to sell everything to the world, you have to save more than you are investing at home, and use the money you get from selling stuff to the world to buy foreign assets.

If your saving and investment do not change, your export position cannot change.

Now, what happens if the Administration puts a 100% tariff on everything imported, but we do not change savings and investment? Well, the total volume of imports - exports can't change. So the dollar has to go up relative to foreign currencies so that the after tax price of exports has not changed.

I hope that is not too simplified -- Im holding a lot of general equilibrium effects constant. Trade experts feel free to chime in in the comment if I am not clear or screwed that up somehow.

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Update 2: The Washington Examiner does a much better and more detailed job on economic policy by fiat and waiver, though still missing, I think, the greatest danger:

Similarly [as with current tariffs and subsidies], President Barack Obama was able to help companies with taxes and regulations that protected them, with bailouts that rescued them, with a stimulus that subsidized them, and with massive federal programs that padded their profits. 

General Electric, Chrysler, Goldman Sachs, Netflix, Boeing, H&R Block, Solyndra, and many other companies benefited, if fleetingly, from Obama’s big-government policies. Conservatives and Republicans generally didn’t applaud these “pro-business” policies even though they created jobs at these favored companies. 

Instead, Republicans rightly charged Obama with “picking winners and losers.” ...
GE CEO Jeff Immelt heralded the Obama era with a shareholder letter declaring the “reset” of capitalism. “The interaction between government and business will change forever. In a reset economy, the government will be a regulator; and also an industry policy champion, a financier, and a key partner.” 

Tax them, regulate them, subsidize them, bail them out. 

This was the clear and deliberate structure of Obamanomics. Fewer profits were to be earned separate of government. More profits were to be earned in partnership with government. 

That’s where Trumponomics is headed. Trump’s tariffs on China have spurred Chinese tariffs on American soybeans. "No problem," Trump declares, "we’ll just use a New Deal law to subsidized soy bean farmers."
....
Also, forcing business to run the government gauntlet tilts the playing field toward the big guys who can afford the lawyers and lobbyists.

The one thing missing is in that last sentence. It's not just about affording lawyers and lobbyists. It's about showing support for the Administration.  Both left and right wing autocracies dispense economic favors in return for political support, or at least acquiescence. People worried about authoritarianism, this is your worry. This is how China and Russia work. And don't mistake this as Trump hysteria. This was my complaint about the Obama administration, and it seems pretty clear that  Democrats have no interest in reining in the regulation, waiver, executive order state, they just want to capture it back for themselves.

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Shorter Papers

Ben Leubsdorf at the WSJ does a great job of covering the discussion within economics over too-long papers, picky editing and refereeing, and other issues.

Defensive writing is certainly part of the issue

“If you want to publish a paper in a top journal, even if you think you have one key insight that can be conveyed succinctly, the referees are not going to take it,” Ms. Finkelstein said.

I think Amy would want to clarify this means referees at other journals. Editors are also to blame. We must remember, referees do not take or reject papers, referees advise editors, and it is always the editor's job to make publication decisions.

From an early stage of an academic career, “it becomes pretty clear that you need to check off a pretty long list of items to really convince people that the way you’re interpreting your results is indeed the right way to do it,” Mr. Bazzi said.

..... When you’re trying to anticipate possible criticisms on a controversial topic like the minimum wage, and situate your research in the deep existing literature on the subject, it “quickly adds up to a long paper,” said University of Massachusetts-Amherst economist Arindrajit Dube,....

Mr. Dube said that paper is now in the process of being revised ahead of publication—including acting on a request to make it shorter.

However, journals don't encourage length, and there is some sense to the current equilibrium.  You write a paper with lots of defensive "what if this what if that." You send it to journals. My typical paper is rejected at 2-3 journals, so by the time it's published I have 6 to 12 reports.  My referees are typically thoughtful and diligent, and the paper grows in addressing all of their what-abouts too. Since I haven't been doing detailed empirical work lately, the requests are not nearly as extensive as those authors receive. Then we finally arrive at publication, and the editor says "now cut it down to 40 pages. You can stuff all that into an internet appendix if you like." Which nobody reads.

This isn't necessarily a bad equilibrium.

Nobel Symposium on Money and Banking Day 2

Day 2 of the Nobel Symposium on Money and Banking focused on monetary policy. (My last post covered Day 1 on banking.)

Bernanke

Sadly Ben Bernanke's video and slides are not up on the website. Ben showed some very interesting evidence that the crisis was an unpredictable run, rather than the usual story about predictable defaults resulting from too much credit. Things really did get suddenly a lot worse in September and October 2008. Yes, it's easy to say this is defense against the charge that he should have done more ahead of time. But evidence is evidence, and I find it quite plausible that the relatively small losses in subprime need not have caused such a massive crisis and recession absent a run. Ben says the material is part of a paper he will release soon, so look for it. One can understand that Bernanke is careful about releasing less than perfect drafts of papers and videos.

History

Barry Eichengreen gave a scholarly account of why history matters, especially the great depression, and we should pay more attention to it. (Paper, video.) He aimed squarely at typical economists whose knowledge stopped at Friedman and Schwartz, or perhaps Ben Bernanke's famous non-monetary channels paper, in which bank failures propagated the depression. He emphasized the role of the gold standard and international cooperation or non-cooperation, and warned against facile comparisons of the gold standard experience to today's events and the euro in particular.

Randy Kroszner has a great set of slides and an engaging presentation. He also started on parallels with the great depression, and told well the story of the US default on gold clauses. He closed with a warning about fighting the last war -- particularly apt given the exclusive focus of most of this conference on the events of 2008 -- and on how to start a crisis. In his view when Bank of England Gov Mervyn King said: “We will support Northern Rock." People hear "Northern Rock's in trouble? Run!" Likewise, in my view, speeches by President Bush and Treasury Secretary Paulson did a lot to spark the run in the US.

DSGE

A highlight for me, was the session on DSGE models.

Marty Eichenbaum (video, slides, subsequent paper) gave a nice review of the current status of new Keynesian DSGE models, and how they are developing in reaction to the financial crisis and recession, and the zero bound episode.

Harald Uhlig

Critiques, or more precisely lists of outstanding puzzles and challenges, are often more memorable and novel than positive summaries, and Harald Uhlig delivered a clear and memorable one. (Video, Slides)

Asset prices are a longstanding problem in DSGE models. In typical linearized form, the quantity dynamics are governed by intertemporal substitution, and the asset prices by risk aversion, and neither has much influence on the other. (I learned this from Tom Tallarini.) Rather obviously, our recent recession was all about risk aversion -- people stopped consuming and investing, and tried to move from private to government bonds because they were scared to death, not a sudden attack of thriftiness. There is a lot of current work going on to try to repair this deficiency, but it still lives in the land of extensions of the model rather than the mainstream. Harald also points out a frequently ignored implication of Epstein-Zin utility, the utility index reflects all consumption and anything that enters utility

Financial frictions are blossoming in DSGE models, in two forms: First, HANK or "heterogenous agent" models, which add things like borrowing constraints and uninsurable risks so that the distribution of income matters, and in an eternal quest to make the models work more like static ISLM. Second, in response to the financial crisis (see first day!) stylized models of banking and intermediary finance are showing up. I'm still a little puzzled that the more standard time-varying risk aversion part of macro-finance got ignored, (a plea here) but that is indeed what's going on.

The conundrum, here as elsewhere in DSGE, is that the more people play with the models, the further they get from their founding philosophy: macro models that do talk about monetary policy, (now) financial crises, but that obey the Lucas rules: Optimization, budget constraints, markets, or, more deeply, structures that have some hope of being policy invariant and therefore predictions that will survive the Lucas critique. Already, many ingredients such as Calvo pricing are convenient parables, but questionably realistic as policy-invariant.

Harald points out that since most of the frictions are imposed in a rather ad-hoc manner, neither will they be policy-invariant. This is a deeper and more realistic point than commonly realized. Every time market participants hit a "friction," they tend to innovate a way around that friction so it doesn't hurt them next time. Regulation Q on interest rates was once a "friction," and then the money market fund was invented. The result is too often "chicken papers:"

The understandable trouble is, if you try to microfound every single friction from Deep Theory -- just why it is that credit card companies put a limit on how much you can borrow, in terms of asymmetric information, moral hazard, and so forth -- the audience will be asleep long before you get to the data. Also, as we saw in day 1, there is (to put it charitably) a lot of uncertainty in just how contract or banking theory maps to actual frictions. I think we're stuck with ad-hoc frictions, if you want to go that route.

Harald's next point is, I think, his most devastating, as it describes a huge hole in current models that is not (unlike the last two) a point of immense current research effort. The Phillips curve and inflation are the central point of the New Keynesian DSGE model -- and a disaster. 

The Phillips curve is central. The point of the model is for monetary policy to have output effects. Money itself has (rightly) disappeared in the model, so the only channel for monetary policy to work is via the Phillips curve. Interest rates change inflation, and inflation causes output changes. No surprise, it is very hard for that model to produce anything like the last recession out of small changes in inflation. (I have to agree here with the premise of the financial frictions view -- if you want your model to produce the last recession, other than by one huge shock, the model needs something like a financial crisis.)

The Phillips curve in the data is well known

Less well known, but worth lots of attention, is how the now standard DSGE models completely fail to capture inflation. Harald's slide:

The point of the slide, in simpler form: The standard Phillips curve is

inflation today = beta x expected inflation next year + kappa x output gap  + shock

Essentially all inflation is accounted for by the shock. The model is basically silent about the source of inflation. Looking at the model as a whole, not just one equation, Neither monetary policy shocks nor changes in rules accounts for any significant amount of inflation. 

I made a similar graph recently. Use the standard three equation model

Now, use actual data on output y, inflation pi, and interest rate i, to back out the shocks v. Turn off the monetary policy shock vi = 0. Solve the model and plot the data -- what would have happened if the Fed had exactly followed the Taylor rule? 

Answer: Inflation and output would have been virtually the same. The inflation of the 1970s and its conquest in the 1980s had nothing to do with monetary policy mistakes. It is entirely the fault, and then fortunate consequence, of "marginal cost" shocks that come from out of the model. This is a pretty uncomfortable prediction of a model designed to be about monetary policy! Or, as Harald put it

• Data: no Phillips-Curve tradeoff.
• QDSGE: don’t account for inflation with monetary policy shocks.
• The NK / Phillips-Curve-based NK QDSGE models may thus provide a poor guide for monetary policy.

Wait, you ask, what about Marty Eichenbaum's pretty graphs, such as this one, showing the effects of a monetary policy shock?

The answer: After a lot of work, the effects of a monetary policy shock look (at last) about like what Milton Friedman said they should look like in 1968. But monetary policy shocks don't account for any but a tiny part of output and inflation variation, quite contra Friedman (and Taylor, and many others') view.

Last, standard new Keyensian DSGE models have strong "Fisherian" properties. In response to long lasting or expected interest rate rises, inflation goes up. More on this later.

Ellen McGrattan

Ellen stole the show. (Slides.) Take a break, and watch the video. She manages to be hilarious and incisive. And unlike the rest of us, she didn't try to sheohorn a two hour lecture into her 15 minutes.

Her central points. First, like Harald, she points out that the models are driven by large shocks with less and less plausible structural interpretation, and thus further from the Lucas critique solution than once appeared to be the case. The shocks are really "wedges," deviations from equilibrium conditions of the model with unknown sources

What to do? Focus on rules and institutions. This is a deep point. Even DSGE modelers, in the desire to speak to policy makers, often adopt the static ISLM presumption that policy is about actions, about decisions, whether to raise or lower the funds rate. The other big Lucas point is that we should think about policy in terms of rules and institutions, not just actions.

Monetary policy and ELB

Stephanie Schmitt-Grohé (slides, video)  talked about the Fisherian possibility -- that raising interest rates raises inflation. New-Keynesian DSGE models, with rational expectations, have this property, especially for permanent or preannounced interest rate increases, and when at zero interest rates or otherwise in a passive regime where interest rates do not react more than one for one with inflation. She and Martin Uribe have been advocating this possibility as a serious proposal for Europe and Japan that want to raise inflation.

She presented some nice evidence that permanent increases in interest rates do increase inflation -- and right away, not just in the long run.

Mike Woodford. (slides, video)  gave a dense talk (37 slides, 20 minutes) on policy at the lower bound. During the ELB, central banks moved from interest rates to asset purchases and forward guidance. Mike asks,

To what extent does this mean that the entire conceptual framework of monetary stabilization policy needs to be reconsidered, for a world in which ELB might well continue periodically to bind? 

In classic form, Mike sets the question up as a Ramsey problem. Given a DSGE model, what is the optimal policy, given that interest rates are occasionally constrained? He derives from that problem a price level target. The price level target works, intuitively, by committing the central bank to a period of extra inflation after the zero bound ends. It is a popular form of forward guidance. The innovation here is to derive that formally as an optimal policy problem.

Mike's price level target is stochastic, changing optimally over time to respond to shocks. I'm a little skeptical that the central bank can observe and understand such shocks, especially given the above Uhlig-McGrattan discussion about the nature of shocks. Also, as I emphasize in comments, I'm dubious about the great power of promises of what the central bank will do in the far future to stimulate output today. I'm a fan of price level targets, but on both sides, not just as stimulus, but for utterly different reasons.

Mike takes on rather skeptically the common alternative -- quantitative easing, asset purchases during the time of the bound. He points out that to work, people have to believe that the increase in money is permanent, and won't be quickly withdrawn when the zero bound is over. As evidence, he points to Japan:

Similarly, he likes the price level target over forward guidance -- speeches in place of action -- as it is a more credible commitment to do things ex-post that the bank may not wish to do ex-post.

Finally, he addresses the puzzles of new Keynesian models at the zero bound -- forward guidance has stronger effects the further in the future is the promise; effects get larger as prices get less sticky, and so on. He argues that models should replace rational expectations with a complex k-step iterated expectations rule.

Me.

Video, slides from Sweden, slides from my webpage, written version. I covered this in a previous blog post, so won't repeat it all. I put a lot of effort in to it, and it summarizes a lot of what I've been doing in 15 minutes flat, so I recommend it (of course). It also offers more perspective on above points by Mike and Stephanie. My favorite line, referring to Mike's push for irrational expectations is something close to

"I never thought we would come to Sweden, that I would be defending the basic new-Keynesian program, and that Mike Woodford would be trying to tear it down. Yet here we are. Promote the fiscal equation from the footnotes and you can save the rest." 

Emi Nakamura

Poor Emi had to go last in an exhausting conference of jet-lagged participants. She did a great job (video, slides) covering a century of monetary history and monetary ideas clearly and transparently. These are great slides to use for an undergraduate or MBA class on monetary policy, as well. An abbreviated list:

• Gold standard
• Seasonal variation in interest rates under the gold standard; money demand shocks
• Money demand shocks in the 1980s -- how the supposedly "stable" V in MV=PY fell apart when the Fed pushed on M.
  
  
  
• Theoretical instability / indeterminacy of interest rate targets
• The switch to interest rate targets and corridors in operating procedures
• The (near-miraculous) success of inflation targets
  
• Taylor rules and other theory of determinate inflation under interest rate targets
• How is it "monetary economics" without money?
• Why did immense QE not cause inflation? 

The overarching theme is the grand story of a move, intellectual and practical, from money supply targets (of which gold is one) to interest rate targets.

Postlude

Monday featured two panels, Macroeconomic research and the financial crisis: A critical assessment, with Annette Vissing-Jørgensen, Luigi Zingales, Nancy Stokey, and  Robert Barro ; and Banking and finance research and the financial crisis: A critical assessment with Kristin Forbes, Ricardo Reis, Amir Sufi, and Antoinette Schoar.

Perhaps it's in the nature of panels, but I found these a disappointment, especially compared to the stellar presentations in the main conference. Also I think it would have been better to allow more (any, really) audience questions; the whole conference was a bit disappointing for lack of general discussion, especially with such a stellar group.

In particular, Luigi led by excoriating the profession for not paying attention to housing problems and financial crises. I thought this a bit unfair and simultaneously short-sighted. He singled out monetary economics textbooks, including Mike Woodford's, for omitting financial crises. Well, Mike omitted asteroid impacts too. It isn't a book about financial crises. And, after lamabasting all of us, he said not one word about events since 2009. What are we missing now? I had to stand up and ask that rude question, again suggesting that perhaps we are all not listening to Ken Rogoff this time. Annette went on to ask something like "don't you Chicago people believe in any regulation at all," and the respondents were too polite to say what an unproductive question that is and just move on.

Again, I offer apologies to authors and discussants I didn't get to. The whole thing was memorable, but there is only so much I can blog! Do go to the site and look at the other sessions, according to your interests.

Nobel Symposium on Money and Banking Day 1

I attended the Nobel Symposium on Money and Banking in May, hosted by the Swedish House of Finance and Stockholm School of Economics.   It was a very interesting event. Follow the link for all the presentations and videos. (Click on "program." )

This review is  idiosyncratic, focusing on presentations that blog readers might find interesting. My apologies to authors I leave out or treat briefly -- all the presentations were action-packed and even my verbose blogging style can't cover everything.

"Nobel" in the title has a great convening power! The list of famous economists attending is impressive. And each presenter put great effort into explaining what they were doing, in part on wise invitation from the organizers to keep it accessible.  As a result I  understood far more than I do from usual 20 minute conference presentations and 15 minute discussions.

The first day was really "banking day," giving a whirlwind tour of the financial economics of banking.

Trading liquidity

Darrell Duffie gave (as always) a super presentation on the effects regulation is having on arbitrage in markets. (Slides, video)

Health care competition?

Continuing the health care series, there does come a time in which innovative disruptors can break open a protected market and bring some competition. Think Uber and taxis. In a very nice essay, John Goodman describes one such effort, MedBid, an online marketplace where hospitals (gasp) bid for your business:

[entrepreneur Ralph] Weber says MediBid got about 3,500 requests last year from patients; and providers made 12,000 bids on those requests. ...

The average knee replacement on MediBid costs around $15,000. The normal charge by U.S. hospitals is around $60,000 and the average insurance payment is about $36,500.  A similar range exists for hip replacements, with an average Medibid price of about $19,000.

Recall prices of $180,000 per hip in my last post. The most interesting feature of Goodman's essay is the nature of price discrimination hospitals practice. It turns out they will negotiate lower prices for cash customers... Sometimes:

...Canadians can come to the U.S. and pay about half as much as we Americans pay. By taking advantage of Medibid, you and I can do the same thing. So can employer health plans. 

So which hospitals are giving Canadians and MediBid patients 50% off? It could easily be a hospital right next door to you. Strange as it may seem, hospitals are willing to give traveling patients deals that they won’t give those of us who live nearby. 

The reasons? Hospitals believe that if you live in their neighborhood, they’re going to get your business, regardless. Also, after your operation, your insurance company might argue over whether the operation should have been done in the first place. They might argue that there was no pre-authorization. They may argue over price. They may argue over many other things. And when the hospital finally gets its money, it might be a year or two after the fact. 

The “medical tourism market,” as it’s sometimes called, has three requirements: (1) you have to be willing to travel and (2) you have to pay up front, and (3) there can be no insurance company interference after the fact. 

This last part is really interesting. You have to travel to get the discount.

We'll see how long the price discrimination lasts in the face of a market that organizes people around it. More and more people have high copayment policies, ACA policies that have such narrow networks they can't get the treatment they want, health savings accounts and so forth. Employers can steer you to Medbid as well.

Cross subsidies again -- hip replacement edition

From the Wall Street Journal, a familiar story of medical pricing mischief:

Michael Frank...had his left hip replaced in 2015. The Manhattan hospital charged roughly $140,000. The insurance company paid a discounted rate of about $76,000, and his share—a 10% copay, plus a couple of uncovered expenses—was a bit more than $8,000. 

The author, Steve Cohen

I’d recently had two hips replaced, six months apart, at the same hospital that had treated him....the hospital had charged $175,000 for my right hip and $180,000 for the left. The insurance company had paid discounted rates of $75,000 and $77,000. 

The usual picture is a huge sticker price, an "insurance discount" and Medicare and Medicaid paying even less than that. I googled around a bit looking for the latter numbers, which I didn't find but I did find here a nice study of cost variation

The average typical cost for a total knee replacement procedure was $31,124 in 64 markets that were studied. However, it could cost as little as $11,317 in Montgomery, Alabama, and as high as $69,654 in New York, New York. Within a market, extreme cost variation also exists. In Dallas, Texas, a knee replacement could cost between $16,772 and $61,585 (267 percent cost variation) depending on the hospital. 

Similar trends also were seen for the average typical cost for a total hip replacement procedure, which averaged $30,124. However, it could cost as little as $11,327 in Birmingham, Alabama, and as much as $73,987 in Boston,5 Massachusetts, which had the greatest variance within a given market, with costs as low as $17,910 (313 percent cost variation). 

These are, I think, insurance costs not the above sticker prices. Also from the LA times,

New Medicare data show that Inglewood's Centinela Hospital Medical Center billed the federal program $237,063, on average, for joint replacement surgery in 2013. That was the highest charge nationwide. And it's six times what Kaiser Permanente billed Medicare eight miles away at its West L.A. hospital. Kaiser billed $39,059, on average, and Medicare paid $12,457. The federal program also paid a fraction of Centinela's bill -- an average of $17,609 for these procedures.

That does give some sense that Medicare is paying even less than private insurers.

Economics

What's going on here? Observations:

1) This market is grotesquely uncompetitive. In any competitive market, suppliers bombard you with price information to get you to shop, and prices are driven to something like cost. Airlines don't need a government run nonprofit to disclose how much they charge. There is not just massive price-based competition for flights, there is massive competition for price-shopping services -- google flights vs. orbitz vs. kayay vs. priceline vs. expedia and so on.

2) The insane list price, the insurance discount of about half, and medicare paying about half that is telling. You would expect a cash discount. There are people with $30k to spend, insurance that doesn't cover hip surgery, and hospitals should be jumping to serve them, cash and carry, no paperwork. There are plenty of people with that kind of money to spend on cosmetic surgery.

The clearest sign of pathology in US health care is that the cash market is dead. Even if you have the money, you must have an insurer to negotiate the "insurance discount."

I suspect that in fact if you go to the hospital and say you're paying cash and negotiate, you can get a much better deal. So long as you don't let anyone else know what you're paying. But even that is no defense. You don't have to go visit airline offices and negotiate one on one for a ticket to New York. Competitive businesses chase after their cash customers. And people with $30k to spend on hip replacements don't want to spend weeks negotiating.

Why don't they advertise? Hospitals cannot publicly say what the cash price is. If they did, insurance would demand that price too and the cross subsidies would vanish.

The quoted price is a fiction. It allows hospitals to declare lots of charity care when they treat uninsured people with no money at all. But more importantly, it gives them a great starting point for a one-on-one ex-post negotiation for the unwary.

As in "cross subsidies," we have an immense scheme of cross-subsidies going on, in which private insurance at $70k overpays compared to Medicare, and the hospital is left free to fleece the unwary with outrageous $140k bills. Cross subsidies cannot withstand competition.

3) The huge price variation gives some sense how wasteful the system is. In addition to the obvious variation across hospitals in a given town, variation across cities is telling.

Google flights shows $591 for a first class ticket from New York to Birmingham Alabama, and the most expensive hotel I can find there is $177 per night. Why not fly to Alabama? Well, of course, insured patients are insured. And insurance is, per law, state based, so Alabama is out of network!

Regulations 

The government needs to do something about this, right? Steve mentions one apparently failed effort,

In 2009, New York’s then-attorney general, Andrew Cuomo, announced the creation of a nonprofit organization called FAIR Health. Its mandate is to provide consumers accurate pricing information for all kinds of medical services. 

I found the FAIR Health website and queried its database. It reported that the out-of-network price for a hip replacement in Manhattan was $72,656, close to what Mr. Frank’s and my insurance companies had paid. The problem: We were both in-network, and FAIR Health estimated that cost as only $29,162. 

I never did figure out the reason for the difference in pricing—but somebody ought to.

The second natural response, which we hear over and over, is that the government needs to pass rules mandating price disclosure. But what happens when the government forces price disclosure and companies (evidently) don't want to tell customers what the price is? Well, there are rules mandating price disclosure for hotel rooms, which must be posted on the door of the hotel room.

Yet on the hotel's website,

Well, that regulation is working great isn't it.

It's easy to jump to the conclusion that people need more skin in the game, greater copays, greater incentive to shop. But the real problem is lack of supply competition. Incentive to shop is no good if you can't find out what things actually cost.

The problem is that hospitals don't want to tell you the price to attract your business. They don't want to because they don't have to, because they are protected from competition.

Hotels do want to tell you the real price. Until hospitals do too, they will find their way around disclosure regulations too. It's easy to post phony prices and wink that nobody actually pays that price.  Hospitals already do that when forced to disclose by stating huge prices and then offering insurers bundle discounts separated from the individual bill. 

Loss Aversion

A frequent email correspondent asked "I’d love to hear your take on “loss aversion.” I just finished listening to Kahneman’s book." My response seems worth sharing with blog readers.

Expected Utility

Let’s review expected utility first. The utility you get from consumption or wealth is a concave function of consumption or wealth. An extra dollar makes you more happy than it makes Bill Gates. So, compare either getting C for sure, or a 50/50 bet of getting C+Delta or C-Delta, i.e. having C or betting 50/50 on a coin flip. The expected utility of C for sure is just U(C). The expected utility of the bet is

EU = prob(loss) * U(consumption if loss) + prob(gain) * U(consumption if gain)

EU = 1/2 * U(C - Delta) + 1/2 * U(C + Delta).

As the graph shows, this is less than the expected utility of C for sure. So, people should decline fair value bets. They are “risk averse”.

Comments. Behavioral fans (New York times has done this often in its economics coverage) criticize “classical economics” by saying it ignores the fact that people fear losses more than they value gains. That’s absolutely false. Look at the utility function. People fear losses more than they value gains. That’s the whole point of expected utility. (You’ll see the confusion in a second).

A common mistake: EU( C) is not the same as U [ E(C )]. You do not find the utility of expected consumption, you find the expected utility of consumption. In my graph, C is equal to the expected value of C-Delta and C+Delta, and the whole point is that the utility of C is bigger than the expected utility of (C-Delta) or (C+Delta). You can take E inside a linear function, but you cannot take E inside a nonlinear function.

Loss aversion

OK, on to loss aversion. In the usual sort of experiments Kahneman found that people seem reluctant to lose money. They have a “reference point” and work  hard to avoid bets that might put them below that reference point. He models that as expected utility with a kink in it, as in the second drawing.

I was careful to draw the reference point as different than C. People do not necessarily place the reference point at the expected value of the bet. In fact, usually they don’t. If betting on stocks, the expected value of the bet is to gain 7% per year. The “don’t lose money” point would be do not go below 0, not do not go below the mean. Here people are especially afraid only of the very left part of the distribution.

Now, really, how are these models different? Expected utility can be any function, and nobody said it doesn’t have a kink in it. The key distinguishing feature of loss aversion – and its Achilles heel – is that the reference point shifts around. If you make some money, and play again, then your kink shifts up to the new amount of money you made. Expected utility is supposed to stay the same function of consumption or wealth. People might change behavior – most likely the utility curve is flatter at high levels of consumption, so rich people are less risk averse. But the curve itself does not shift. The key assumption that distinguishes loss aversion from expected utility is that the kink point shifts around as you gain and lose money.

That’s also the Achilles heel.  The first problem is how do you handle sequential bets. If I go to the casino, and know I will play twice, how do I think about my strategy? With expected utility this is easy, because the expected utility works backwards. Suppose you win the first bet, then figure out what you do in the second bet. For each of win or loss in the first bet, then, you have an expected utility from taking the second bet. The expected utility of the first bet is then the expected vaule of the expected utilities you would have if you won or lost.