Hope from the left

One ray of hope in the current political scene comes from the land of deep blue.  However one views the immense expenditure on solar panels, windmills and electric cars, (produced in the US by US union labor, of course), plus forced electrification of heat and cooking, a portion of the blue-state left has noticed that this program cannot possibly work given laws and regulations that have basically shut down all new construction. And a substantial reform may follow.  

I am prodded to write by Ezra Kleins' interesting oped in the New York Times, "What the Hell Happened to the California of the ’50s and ’60s?," a question repeatedly asked to Governor Gavin Newsom. The answer is, of course "you happened to it." For those who don't know, California in the 50s and 60s was famous for quickly building new dams, aqueducts, freeways, a superb public education system, and more.   

Gavin Newsom states the issue well. 

"..we need to build. You can’t be serious about climate and the environment without reforming permitting and procurement in this state.”

You can't be serious about business, housing, transportation, wildfire control, water, and a whole lot else without reforming permitting and procurement, but heck it's a start. 

The perennial fantasy

Two attacks, and one defense, of classical liberal ideas appeared over the weekend. "War and Pandemic Highlight Shortcomings of the Free-Market Consensus" announces Patricia Cohen on p.1 of the New York Times news section.  As if the Times had ever been part of such a "consensus." And Deirdre McCloskey reviews Simon Johnson and Daron Acemoglu's "Power and Progress," whose central argument is, per Deirdre, "The state, they argue, can do a better job than the market of selecting technologies and making investments to implement them." (I have not yet read the book. This is a review of the review only.) 

I'll give away the punchline. The case for free markets never was their perfection. The case for free markets always was centuries of experience with the failures of the only alternative, state control. Free markets are, as the saying goes, the worst system; except for all the others. 

In this sense the classic teaching of economics does  a disservice. We start with the theorem that free competitive markets can equal -- only equal -- the allocation of an omniscient benevolent planner. But then from week 2 on we study market imperfections -- externalities, increasing returns, asymmetric information -- under which markets are imperfect, and the hypothetical planner can do better. Regulate, it follows. Except econ 101 spends zero time on our extensive experience with just how well -- how badly -- actual planners and regulators do. That messy experience underlies our prosperity, and prospects for its continuance. 

Starting with Ms. Cohen at the Times, 

The economic conventions that policymakers had relied on since the Berlin Wall fell more than 30 years ago — the unfailing superiority of open markets, liberalized trade and maximum efficiency — look to be running off the rails.

During the Covid-19 pandemic, the ceaseless drive to integrate the global economy and reduce costs left health care workers without face masks and medical gloves, carmakers without semiconductors, sawmills without lumber and sneaker buyers without Nikes.

That there ever was a "consensus" in favor of "the unfailing superiority of open markets, liberalized trade and maximum efficiency" seems a mighty strange memory. But if the Times wants to think now that's what they thought then, I'm happy to rewrite a little history. 

Face masks? The face mask snafu in the pandemic is now, in the Times' rather hilarious memory, the prime example of how a free and unfettered market fails. It was  a result of "the ceaseless drive to integrate the global economy and reduce costs?" 

The barn door

Kevin Warsh has a nice WSJ oped warning of financial problems to come.  The major point of this essay: "countercyclical capital buffers" are another bright regulatory idea of the 2010s that now has fallen flat. 

As in previous posts, a lot of banks have lost asset value equal or greater than their entire equity due to plain vanilla interest rate risk. The ones that haven't run are now staying afloat only because you and me keep our deposits there at ridiculously low interest rates. Commercial real estate may be next. Perhaps I'm over-influenced by the zombie-apocalypse goings on in San Francisco -- $755 million default on the Hilton and Parc 55, $558 million default on the whole Westfield mall after Nordstrom departed and on and on. How much of this debt is parked in regional banks? I would have assumed that the Fed's regulatory army could see something so obvious coming, but since they completely missed plain vanilla interest rate risk, and the fact that you don't have to stand in line any more to run on your bank, who knows?

So, banks are at risk; the Fed now knows it, and is reportedly worried that more interest rates to lower inflation will cause more problems. To some extent that's a feature not a bug -- the whole theory behind the Fed lowering inflation is that higher interest rates "cool economic activity," i.e. make banks hesitant to lend, people lose their jobs, and through the Phillips curve (?) inflation comes down. But the Fed wants a minor contraction, not full-on 2008. (That did bring inflation down though!) 

I don't agree with all of Kevin's essay, but I always cherry pick wisdom where I find it, and there is plenty. On what to do: 

Ms. Yellen and the other policy makers on the Financial Stability Oversight Council should take immediate action to mitigate these risks. They should promote the private recapitalization of small and midsize banks so they survive and thrive.

Yes! But. I'm a capital hawk -- my answer is always "more." But we shouldn't be here in the first place. 

Papers: Dew-Becker on Networks

I've been reading a lot of macro lately. In part, I'm just catching up from a few years of book writing. In part,  I want to understand inflation dynamics, the quest set forth in "expectations and the neutrality of interest rates," and an  obvious next step in the fiscal theory program. Perhaps blog readers might find interesting some summaries of recent papers, when there is a great idea that can be summarized without a huge amount of math. So, I start a series on cool papers I'm reading. 

Today: "Tail risk in production networks" by Ian Dew-Becker, a beautiful paper. A "production network" approach recognizes that each firm buys from others, and models this interconnection. It's a hot topic for lots of reasons, below.  I'm interested because prices cascading through production networks might induce a better model of inflation dynamics. 

(This post uses Mathjax equations. If you're seeing garbage like [\alpha = \beta] then come back to the source  here.) 

To Ian's paper: Each firm uses other firms' outputs as inputs. Now, hit the economy with a vector of productivity shocks. Some firms get more productive, some get less productive. The more productive ones will expand and lower prices, but that changes everyone's input prices too. Where does it all settle down? This is the fun question of network economics. 

Ian's central idea: The problem simplifies a lot for large shocks. Usually when problems are complicated we look at first or second order approximations, i.e. for small shocks, obtaining linear or quadratic ("simple") approximations. 

On the x axis, take a vector of productivity shocks for each firm, and scale it up or down. The x axis represents this overall scale. The y axis is GDP. The right hand graph is Ian's point: for large shocks, log GDP becomes linear in log productivity -- really simple. 

Why? Because for large enough shocks, all the networky stuff disappears. Each firm's output moves up or down depending only on one critical input. 

The Fed and the Phillips curve

I just finished a new draft of "Expectations and the neutrality of interest rates," which includes some ruminations on inflation that may be of interest to blog readers. 

A central point of the paper is to ask whether and how higher interest rates lower inflation, without a change in fiscal policy. That's intellectually interesting, answering what the Fed can do on its own. It's also a relevant policy question. If the Fed raises rates, that raises interest costs on the debt. What if Congress refuses to tighten to pay those higher interest costs? Well, to avoid a transversality condition violation (debt that grows forever) we get more inflation, to devalue outstanding debt. That's a hard nut to avoid.  

But my point today is some intuition questions that come along the way. An implicit point: The math of today's macro is actually pretty easy. Telling the story behind the math, interpreting the math, making it useful for policy, is much harder. 

1. The Phillips curve

The Phillips curve is central to how the Fed and most policy analysts think about inflation. In words, inflation is related to expected future inflation and by some measure if economic tightness, factor \(x\). In equations, \[ \pi_t = E_t \pi_{t+1} + \kappa x_t.\] Here \(x_t\) represents the output gap (how much output is above or below potential output), measures of labor market tightness like unemployment (with a negative sign), or labor costs. (Fed Governor Chris Waller has a great speech on the Phillips curve, with a nice short clear explanation. There are lots of academic explanations of course, but this is how a sharp sitting member of the FOMC thinks, which is what we want to understand. BTW, Waller gave an even better speech on climate and the Fed. Go Chris!)  

So how does the Fed change inflation? In most analysis, the Fed raises interest rates; higher interest rates cool down the economy lowering factor x; that pushes inflation down. But does the equation really say that? 

Cost Benefit Comments

The Biden Administration is proposing major changes to cost-benefit analysis used in all regulations. The preamble here, and the full text here. It is open for public comments until June 20. 

Economists don't often comment on proposed regulations. We should do so more often. Agencies take such comments seriously. And they can have an afterlife. I have seen comments cited in litigation and by judicial decisions. Even if you doubt the Biden Administration's desire to hear you on cost-benefit analysis, a comment is a marker that the inevitable eventual Supreme Court case might well consider. Comments tend only to come from interested parties and lawyers. Regular economists really should comment more often. I don't do it enough either. 

You can see existing comments:  Search for Circular A-4 updates to get to https://www.regulations.gov/docket/OMB-2022-0014, then select “browse all comments.” (Thanks to a good friend who sent this tip.) 

Take a look at comments from an MIT team led by Deborah Lucas here and by Josh Rauh. These are great models of comments. You don't have to review everything.   Make one good point. 

Cost benefit analysis is useful even if imprecise. Lots of bright ideas in Washington (and Sacramento!) would struggle to document any net benefits at all. Yes, these exercises can lie, cheat, and steal, but having to come up with a quantitative lie can lay bare just how hare-brained many regulations are. 

Stephens at Chicago; effective organizations

Brett Stephens gave a great commencement speech (NYT link, HT Luis Garicano) at the University of Chicago. One part stood out to me, and worthy of comment. Bret starts with the problem of Groupthink:

Why did nobody at Facebook — sorry, Meta — stop Mark Zuckerberg from going all in on the Metaverse, possibly the worst business idea since New Coke? Why were the economists and governors at the Federal Reserve so confident that interest rates could remain at rock bottom for years without running a serious risk of inflation? Why did the C.I.A. believe that the government of Afghanistan could hold out against the Taliban for months but that the government of Ukraine would fold to the Russian Army in days? Why were so few people on Wall Street betting against the housing market in 2007? Why were so many officials and highly qualified analysts so adamant that Saddam Hussein had weapons of mass destruction? Why were so many people convinced that overpopulation was going to lead to catastrophic food shortages, and that the only sensible answers were a one-child policy and forced sterilizations?

Oh, and why did so many major polling firms fail to predict Donald Trump’s victory in 2016?

Conspicuous institutional failures are the question of our age We could add the SBV regulatory fiasco, the 2007 financial regulatory failure, the CDC FDA and numerous governments under Covid,  and many more.  Systemic incompetence doesn't just include disasters, but ongoing wounds from the Jones act to California's billions wasted on obviously ineffective homeless spending.