Monday, March 18, 2019

Monopoly in history

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, March 14, 2019

Competitive deposits?

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


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

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



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

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

Pablo also plots data from different countries:


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

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

Wednesday, March 13, 2019

Fed vs. Narrow Banks

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

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

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

You would be wrong.

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

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

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

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

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

Wednesday, January 30, 2019

The death of the healthcare market

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

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

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

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

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

Friday, January 25, 2019

Privatize TSA and ATC!

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

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

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

Monday, January 21, 2019

Carbon tax update

An interesting question emerged from some discussion surrounding my last carbon tax post. How big will the tax be? The letter says $40 a ton, but then rising. But how far? And in response to what question?

It occurs to me that the two obvious targets lead to radically different answers.

1) The social cost of carbon. This is what economists usually think of as the appropriate Pigouvian tax. In order to pollute, you pay the cost you impose on others by your pollution.

Even the worst-case scenarios now put the cost of carbon emissions at 10% of GDP in the year 2100. Discount that back, divide by all the carbon emitted between now and then, and, you're going to get a pretty small tax.

2) Temperature or quantitative guidelines. Or, "whatever it takes to stop the global temperature from rising more than 1.5 degrees C." Such a tax has to be high enough to basically stop us  from using fossil fuels. It would be radically higher, and impose economic costs far higher than 10% of GDP.

When you set a goal of a quantity with no attached price, the price can get pretty high.

I see now some of the back and forth chatter. Anti-carbon types warn that any tax "won't be enough." Now I know what they mean.

So who sets the tax, and on what basis, are important issues we're all fudging over.

Of course, a cynic would take the view that the tax will be set to

3) Maximize government revenue.

Given the behavioral elasticities, that is likely to be a good deal less than #2, as to high a tax will quickly erode the tax base.

PS: to my may CO2-is-not-a-problem commenters. If (or perhaps when) it's all proved to be a hoax, a carbon tax is a lot easier to undo than the alternative regulatory approach!


Lend the shutdown?

The Federal Government seems to be obeying with rather remarkable accuracy the constitutional mandate that the government may not spend money that has not been appropriated by Congress.

I would be curious to hear from legal experts, however, what stops the government from lending money to federal employees, or just guaranteeing loans.

After all the government lends money all over the place, and credit guarantees are even larger. Is the Treasury no longer operating small business loan programs? (Honest question.) Is the Fed no longer lending money to banks, if they want it? Are Fannie and Freddy refusing to buy home mortgages because the funds to guarantee home mortgages (which it does) are not appropriated? No. As far as I can tell, Federal lending and loan guarantee programs are up and running.

If so, what stops the Treasury, from either lending money directly to Federal employees, or guaranteeing private lending. After all, the Treasury will write their back paychecks when the time comes, so these are potentially risk free loans. What stops the Treasury from just writing on a federal employees' paycheck "this is a loan against your back pay?"

Or... Social security and Medicare are still running. Can they write advances against social security payments that will be deducted from future federal paychecks?

I presume there is something stopping this -- that it is a step too clever, like the trillion dollar coin solution to the debt limit. But I would be curious to hear what the limitation is.

(HT Marginal Revolution on federal employees' other sources of financing, at pretty high interest rates.)

Saturday, January 19, 2019

Economists' letter on carbon

The "Economists’ Statement on Carbon Dividends" in the Wall Street Journal this week is a remarkable document. It's short, sweet, and signed by, as far as I can tell, every living CEA chair, every living Fed Chair, both Democrat and Republican, and most of the living Nobel Prize winners. (Thanks to a commenter who corrected an earlier count.)

It offers four principles 1. A carbon tax, initially $40 per ton. 2. The carbon tax substitutes for regulations and subsidies and (my words) the vast crony-capitalist green boondoggle swamp, which is chewing up money and not saving carbon. 3. Border adjustment like VAT have 4. "All the revenue should be returned directly to U.S. citizens through equal lump-sum rebates."

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, January 14, 2019

Volalitily, now the whole thing

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

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

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



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

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

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

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

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

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

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

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



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

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

So what is going on? I hazard a guess.

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

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

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

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

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

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

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

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

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



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

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

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

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

Friday, January 11, 2019

Property tax present value

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

That doesn't seem bad, except that property values are very high. You can't get a tear-down in Palo Alto for under $2 million. If you buy a house that costs 5 times your income -- say someone earning $200,000 per year buying a $1 million house -- then that is equivalent to 5 percentage points additional income tax.  On top of 42% federal, 13.2% state, 9% sales, and other taxes, it's part of my view that we're past 70% top marginal rate now.

The other way to look at taxes is in present value. At 1% interest rate, the value of a 1% payment is $1.00. What that means: Suppose you bought a $1,000,000 house. It's going to cost you $10,000 in property taxes per year. Let's set up an account that will pay your property taxes. If you get 1% interest on that account, you need to put $1,000,000 in the account!

A 1% property tax at a 1% interest rate is equivalent to a 100% tax on houses. That $1,000,000 house is really going to cost you $2,000,000!

There is a general paradox here: The top two things our politicians say they want to encourage are jobs and homeownership. Jobs are perhaps the most highly taxed economic activity in the economy, and by this calculation houses come in a close second.

(California also assesses a 1% personal property tax, on top of a sales tax, for anything they can prove you own, which usually means boats and airplanes. That too is an additional 100% tax.)

The second lesson, the value of wealth taxes depends sensitively on the interest rate, as I'm sure some of you are chomping at the bit to point out. If the interest rate is 2%, then the tax rate is "only" 1/0.02 = 50%. If the interest rate is 5%, then the tax rate is 1/0.05 = 20%. I suspect these taxes were put in place in a time of higher interest ares and nobody is really thinking about the effect of lower rates.

Similarly, suppose the government puts in a 1% per year wealth tax. If wealth generates a 5% rate of return, then the 1% wealth tax is the same thing as a 20% one-time confiscation of value*.  If wealth generates a 1% rate of return, a 1% wealth tax is a 100% confiscation of value**. Mercifully, our income tax system taxes the rate of return, not the principal, and avoids this conundrum. Others do not.

What is the right rate? We can have a lot of fun with that one. The current 30 year TIPS (inflation indexed) rate is 1.19%. The 30 year nominal Treasury rate is 2.97%.  In California, under Proposition 13, you pay 1% of the actual purchase price per year, but that quantity never increases. (This fact results in the paradox of extremely high property taxes on new purchasers, older people staying in huge old houses, and low property tax revenues.) So you might say that the nominal rate applies.

In Illinois, you pay a percentage of assessed value, which is usually a good deal lower than the actual value. (It also leads to a fun game of fighting over what the assessed value is. No surprise some of Illinois' most powerful politicians are also lawyers whose firms argue property assessment cases. ) That means however that the real interest rate matters.

But in both cases, we need to use the after-tax rate. If you put your money in a 30 year treasury (or a long-term bond fund that keeps a long maturity), you pay taxes on the interest. If your marginal tax rate (federal + state + local) is 50%, that means you only get half the interest. So that 3% nominal yield is really a 1.5% nominal yield, and the Californian should use a 1.5% rate, resulting in a 1/0.015 = 66% tax rate.

The tax treatment of TIPS is more complicated. (Really, inflation protected bonds are a great idea, but did the Treasury have to screw up the tax treatment so thoroughly?) You pay taxes on the nominal interest payments, and also on increases in principal value. This causes an accounting mess that I don't want to get into here, but as a rough guide, if you are in a 50% marginal tax bracket, then you need to buy $200 worth of TIPS to generate a $1.00 after-tax stream. So, if you live in a state where property tax assessments rise over time, we're really talking about 2  x 1/0.01 = 200% tax rate on the initial assessed value.

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

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

The back of my envelope is full.

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

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

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

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

Sunday, January 6, 2019

Krugman on optimal taxes

As you may have noticed, I try very hard not to get in to the business of rebutting Paul Krugman's various outrages. The article "The economics of soaking the rich" merits an exception. I will ignore the snark, the... distoritions, the ... untruths, the attack by inventing evil motive, the  demonization of anything starting with the letter R, and focus on the central economic points.

Paul correctly cites recent work by Diamond and Saez, estimating the optimal top marginal tax rate at 70%, and Christina Romer's concurring opinion.

The howlers are well epitomized by

"Why do Republicans adhere to a tax theory that has no support from nonpartisan economists and is refuted by all available data? Well, ask who benefits from low taxes on the rich, and it’s obvious.

And because the party’s coffers demand adherence to nonsense economics, the party prefers “economists” who are obvious frauds and can’t even fake their numbers effectively."

1) 70% is not carved in stone.

Diamond and Saez made a big splash precisely because their estimates were so novel and so much higher than the prevailing consensus. For example, Greg Mankiw, also a previous CEA chair, and not a fraud, writing the excellent "Optimal Taxation in Theory and Practice" in the Journal of Economic Perspectives, a nonpartisan (or left-leaning) academic journal, not a fraud, with with Matthew Weinzierl and Danny Yagan, writes
A well-known early result of the Mirrlees (1971) model is the optimality of a zero top marginal tax rate. ...
All this leaves the policy advisor in an uncomfortable position. Early work, following Mirrlees (1971), assumed a shape for the ability distribution, a social welfare function, an individual utility function, and a pattern of labor supply elasticities that yielded clear and surprising results— declining marginal tax rates at the top of the income distribution. Some recent work has yielded dramatically different results more consistent with existing policy, but many of the key assumptions are open to debate.
... 
Lesson 3: A Flat Tax, with a Universal Lump-Sum Transfer, Could Be Close to Optimal 
The claim that the optimal marginal tax schedule is generally flat has been challenged often in the nearly four decades since Mirrlees (1971). Most prominently, Saez (2001) finds optimal tax rates that increase steadily from incomes around $50,000 to $200,000. Of course, the optimal tax schedule is sensitive to assumptions about the inputs discussed in the previous lesson: the shape of the distribution of abilities, the social welfare function, and labor supply elasticities. None of these three components of the problem is easily pinned down. 
You get the picture, the optimal top tax rate is in fact a highly contentious number, depending on many assumptions, all very hard to measure or even to define really.

As Mankiw et al point out, the position "let's implement textbook optimal taxation theory" might be a bit uncomfortable for Krugman's position that all things that start with D are holy.
Lesson 6: Only Final Goods Ought to be Taxed, and Typically They Ought to be Taxed Uniformly
Lesson 7: Capital Income Ought To Be Untaxed, At Least in Expectation
There is a lot of controversy on these too -- the best way to get an AER publication is to disagree with orthodoxy, but they are still the rough orthodoxy, and there are sensible non-evil people who agree with them.

2) Even in Diamond, Saez, et Al, 70% is the total tax, not the federal income tax, and it is the marginal rate not the average rate.  (Though not always as you'll see in a minute)

We have to add up every wedge between one dollar of extra revenue you create for your employer, and the value of what you receive in turn. That includes the  federal income tax, plus state and local income taxes,  property taxes, excise taxes, estate taxes, and so forth. We have to include sales taxes, personal property taxes, payroll taxes on employees you might hire. We have to include your share of corporate and business taxes (corporations raise prices to pay their taxes, so you're paying in the end). It's a marginal rate -- we have to include phaseouts of tax benefits, and loss of income-related subsidies.

Greg Mankiw calculated his marginal tax rate at over 90% (Sorry, I can't find the link anymore). He thought about, what if he takes a consulting job, pays all tax on it, saves it, paying taxes on dividends and intrerest, gives it to his kids, paying estate taxes, and they spend it. Even greg forgot about sales taxes and property taxes (if they buy a house) in this calculation. In California, where I live, the top rate is at least 42% federal + 13.2% state (not deductible anymore)  + about 10% sales tax + about 6% property tax (1% of house value per year, house = 5 times income) +  .. it goes on like this.

Watch what you wish for. A 70% all in marginal rate might well be a tax cut for many households. I once semi-humorously proposed an alternative maximum tax.

Krugman and company are proposing a 70% top federal rate on top of all the others, which is... a bit deceptive relative to the 70% total marginal tax rate even in his cherry-picked sources.

3) Disincentives. Krugman correctly points out the central tradeoff.
So why not tax them at 100 percent? The answer is that this would eliminate any incentive to do whatever it is they do to earn that much money, which would hurt the economy. 
But then Krugman, and those he cites, take an extremely narrow view of this disincentive effect.

By and large the "optimal redistribution" theory considers only the static question, how many hours will you work.
 If a rich man works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, ...
 And, correctly, I think, this literature by and large agrees with the labor supply literature that once people have found jobs and careers, they tend to work about 40 hours a week or so even at pretty high tax rates. We can argue about that, but I think it's more productive to look at all the margins that are ignored here.

The big margin for economic growth is peoples human capital decisions -- the decision to go to school, to take hard courses (computer programming) rather than softer more pleasant ones, the decisions to start businesses and invest enormous time when young developing them. The optimal redistribution literature just ignores all of this. And, like the decision to relocate, it depends on the total tax bite, not just the marginal tax bite. How much will I earn, after all taxes -- what lifestyle will I lead -- if I go to med school, or just stay where I am? High tax countries do not immediately see people staying home from work. But they do not see vibrant business formation and human capital investment. (Chad Jones has a great new paper on this.)

The other margin is avoidance. Throwing around high statutory tax rates in the 1950s as if anyone actually paid them is past disingenuous at this point, as often as the opposite has been pointed out. (Diamond and Saez engaged at least recognized that nobody paid 90%, but engage in a subtle .. sleight of hand. They assume that all corporate taxes were paid by wealthy people in the 1950s -- the one and only burden or indirect calculation in the paper, and contrary to the usual assumption that capital supply curves are flatter than labor or product demand.)

The one thing we should learn from the New York Times and others' probes in to Trump Tax Land is just how far very wealthy people will go to avoid paying taxes. Especially estate taxes -- there is nothing like the government coming for nearly half your wealth to concentrate the mind. I venture that we would have gotten a lot more out of the Trump family with a 20% VAT and no income tax or estate tax!

A 70% or 80% marginal federal income tax would be first and foremost a boon for tax lawyers and accountants. If one were in the mood to match Krugman's attacks of which party has which dark motives to serve which evil interest, the direction would be easy.

Moreover, Krugman gets the benefit of labor to society wrong in an astonishing econ 1 way
If a rich man [or woman, Paul, please!] works an extra hour, adding $1000 to the economy, but gets paid $1000 for his efforts, the combined income of everyone else doesn’t change, does it? Ah, but it does — because he pays taxes on that extra $1000. So the social benefit from getting high-income individuals to work a bit harder is the tax revenue generated by that extra effort — and conversely the cost of their working less is the reduction in the taxes they pay.
If you are paid your marginal product, as you are in a competitive market, then you are paid how much revenue your efforts add to your employer's bottom line. But society benefits by the consumer surplus, the area under the demand curve, and loses that consumer surplus when taxes put a wedge between your effort and your wage. When Steve Jobs worked hard and sold us all Iphones, he made a ton of money, and apple made a huge profit. But we all benefitted by far more than we paid Apple for the phones.

No, the world is not a static, zero-sum game.

I should add though, that economics really doesn't care how much taxes you, or "the rich" pay. Economics cares about the marginal rate, how much you pay on the extra dollar. There is not much of an economic case, really, for low taxes on the rich, or anyone else, so long as taxes do not distort economic decisions. That's the case for a very broad base -- and a low rate. Krugman et al are beyond misleading if they characterize the case for low taxes as handouts for the rich. No, the case is incentives for the rich -- and everyone else. (Incentives are particularly bad at the low end, where you lose a dollar of benefits for every dollar of earnings.)

4) Garbage in, garbage out.

Every result in economic theory starts from assumptions and derives conclusions. This one is the same. Before we get to the distribution of talent, the accumulation of human capital, and the rest, this whole business starts with the presumption that the US Federal Government is a benevolent dictator, whose job it is to take from Peter to give to Paul -- to maximize the sum of everyone's utility, and yes making intrapersonal comparisons to do it -- constrained only by Peter's willingness to work if faced with a steep tax rate.

If you don't buy that basic assumption, along with all the others along the way, you don't buy the result. If, in particular, you look at the world circa 1850, or even in Krugman's cherished 1950, and you look at how amazingly better off we all are today, and you conclude that the government's job is to foster economic growth as fast as possible, then all bets are off.

No, the world is not a static, zero-sum game, in which we fleece the rich one just enough to keep him playing.

I think it's time to reactivate my no-Krugman new year's pledge.




Friday, January 4, 2019

Selgin on IOER and TNB

George Selgin has a nice piece on TNB and IOER, which I missed when it came out in September, but it's still relevant.

(HT a correspondent. TNB is "The Narrow Bank" which I wrote about here; IOER is interest on excess reserves. The Fed pays banks interest on reserves, which are accounts that banks hold at the Fed.) 

As George points out, TNB's model is to take money from, large corporations or money market funds, invest that money at the Fed as interest-paying reserves, and give as large an interest rate back to the depositors as possible. (Well, that's what their model will be if their suit against the Fed  winds through the US legal system before the next crash, which is unlikely, These customers can't get large enough insured deposits at regular banks; that TNB invests entirely in reserves make it impossible for TNB to fail so its customers don't need insurance. TNB doesn't want to let you or me give them money because that opens them to an immense amount of costly regulation.

The puzzling question is, how can TNB make money at that.?TNB takes money, invests it with the Fed, and the Fed in turn buys US treasuries. How is that better than TNB simply operating a money market mutual fund that invests directly in Treasurys?

The answer is, that for most of the last decade, the Fed has paid more interest on reserves than comparable treasury rates. Yes, "money" pays higher interest than "bonds," an inversion of classic monetary theory. Since money is more liquid, how can this survive? The answer is, because only banks can access this kind of "money." TNB was going to upend that.

Just why does the Fed pay more interest on reserves than comparable treasuries?  This is, like it or not, a nice little subsidy to banks, who get about 0.2% more on their reserves than anyone else can get.

Where does that 0.2% come from? You and me. George explains vividly
Just how is it that the Fed's IOER payments could allow MMMFs to earn more than they might by investing money directly into securities themselves? Because the Fed has less overhead? Don't make me laugh. Because Fed bureaucrats are more astute investors? I told you not to make me laugh! No, sir: it's because the Fed can fob-off risk — like the duration risk it assumed by investing in so many longer-term securities — on third parties, meaning taxpayers, who bear it in the form of reduced Fed remittances to the Treasury. That means in turn that any gain the MMMFs would realize by having a bank that's basically nothing but a shell operation designed to let them bank with the Fed would really amount to an implicit taxpayer subsidy. There Ain't No Such Thing As A Free Lunch... As it stands, of course, ordinary banks are already taking advantage of that same subsidy.
This is good, and I conclude that the Fed should keep a large balance sheet, flood the economy with liquidity as Friedman said it should, and run a tight corridor system paying no more on excess reserves than comparable Treasury rates.  Here we part company.

George seems to agree with the Fed though, that this subsidy is an integral part of the interest on reserves scheme, and that TNB will undermine the whole project of a large balance sheet and targeting interest rates directly via interest on reserves and later, the discount rate. I disagree.

Deregulation

Many of us free-market types bemoan how poorly designed regulation hurts economic growth. But unlike "stimulus," regulation is a death by a thousand knives. Each one seems innocuous, but they add up. It's hard to tell the story without details. There is no handy government statistic on "impact of regulations." We tend to talk about what we can easily measure. Likewise, there is a general sense that the current deregulation effort may be helping, but again without details it's hard to know if this is truth or spin.

In this context, I just learned of an interesting new website at the Brookings Institution that tracks Trump Administration deregulation efforts (HT Daniel Henninger at WSJ).  I get the general sense that Brookings isn't too happy with it and wants to expose removal of useful regulations. But they've done a nice job, so you can read it both ways.

Yes, the big ones you've heard of are there. The Waters of The US Rule, The Coal Fired Powerplants Rule, Title IX, Asylum Seeker restrictions, Fuel Economy standards, lots of rules pecking away at capital standards for financial institutions (so much for procyclical capital!)  and so forth.

It's interesting quite how many are not really Administration deregulations, but compliance with the Supreme court throwing out Obama era regulations. This really is what the Supreme Court battle is about.

It's also interesting actually how short this list is. For all the talk of "deregulation," you would think thousands of individual rules would be on the chopping block.

But I enjoyed this mostly for details for all the little ones you don't read about every day, a little peek into the bowels of the regulatory state.
Affordable Housing Program Amendments 
The Federal Home Loan Bank Act requires each Federal Home Loan Bank to establish an affordable housing program to enable members to provide subsidies for long-term, low- and moderate-income, owner-occupied, and affordable rental housing. 
What? You might have thought Trump officials were going to stage a book burning of that one, but no, it's modest
This proposed rule invites comment on several amendments to the regulations governing Federal Home Loan Banks, among others, giving Federal Home Loan Banks additional authority to allocate their Affordable Housing Program funds and relaxing or streamlining certain regulatory requirements.
Baby steps, baby steps