Time for a new (?) theory of regulation

What's the basic story of economic regulation? 

Econ 101 courses repeat the  benevolent dictator theory of regulation: There is a "market failure," natural monopoly, externality, or asymmetric information. Benevolent regulators craft optimal restrictions to restore market order. In political life "consumer protection" is often cited, though it doesn't fit that economic structure. 

Then "Chicago school" scholars such as George Stigler looked at how regulations actually operated.  They found "regulatory capture." Businesses get cozy with regulators, and bit by bit regulations end up largely keeping competition down and prices up to benefit existing businesses. 

We are, I think, seeing round three, and an opportunity for a fundamentally new basic view of how regulation operates today. 

The latest news item to prod this thought is FCC Commissioner Brendan Carr's scathing dissent on the FCC's decision to cancel $885 million contract to Starlink. Via twitter/X: 

Leonhardt on investment

 David Leonhardt's pean to investment in the Sunday NY Times Magazine starts well:

A cross-country trip today typically takes more time than it did in the 1970s. The same is true of many trips within a region or a metropolitan area....Door to door, cross-country journeys often last 10 or even 12 hours.

Bhattacharya on Covid censorship

A week ago Jay Bhattacharya gave a great talk at the weekly Stanford Classical Liberalism workshop. (Link in case the embed doesn't work.) He detailed the story of government+media Covid censorship, along with the dramatic injunction in the Missouri v. Biden case. The discovery in that case alone, detailing how the administration used the threat of arbitrary regulatory retaliation to get tech companies to censor covid information -- along with other matters, including the Hunter Biden laptop -- is astonishing. We now know what they did, no matter what judges say about its technical legality. 

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. 

The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 

Updates:

Chris Russo wrote in Barrons Sept 2021 reporting on internal Fed strategizing for this event. 

The Fed will treat defaulted Treasury obligations the same as non defaulted obligations. Their regulatory treatment will remain the same including capital requirements and risk weights. Moreover these securities "will not be adversely classified or criticized by examiners." 

Policy makers would "presumably want to avoid the impression that the Federal Reserve was effectively financing government spending." 

The Fed will 

transact with defaulted securities at market prices

Eventually 

The Fed could move the defaulted securities on to its balance sheet [English translation: buy] ...this set of options is the most contentious. Powell described them as "loathsome"... the institutional risk would be huge. The economics of it are right but you'd be stepping in to his difficult political world and looking like you are making the problem go away. Lacker called it "beyond the pale." John Williams... supported keeping those options on the table. ...no Fed governor categorically rejected the third option. 

As I read it, this is considerably less than what I described. The Fed worries here about not inadvertently forcing individual banks to treat treasury assets as defaulted securities, which is good. But the main issue is whether financial markets, many not banks, will accept treasury collateral for lending, or whether we have as in 2008 a grand unwinding of the chain of short-term financing due to lack of collateral. Only the "loathsome" option addresses that issue as far as I can see. And if you want to stem a collateral run, it's best to clarify ahead of time. 

Casey Mulligan inquired

I am confused about your proposal.  Fed is part of the government. With currency in circulation not (?) counting against the debt limit aren't you suggesting the Treasury debt be (contingently) replaced with currency? Or would the Fed be defaulting on whatever asset it lends out?

Boy, if I didn't explain it well enough for Casey, I must really need a remedial writing course. Answer/clarification: 

Sorry if not clear. Fed can buy / lend against existing treasury debt, in default, and offer cash/reserves in exchange. This solves the financial crisis issue. It does not allow the treasury to borrow more, or the Fed to finance deficits. 

Supply and inflation

 Mark Perry recently updated a fabulous chart: 

Not all inflation is the same. 

Some interpretations, from Mark. Tradeable (international competition) / non tradeable; government intervention / free market; durable goods / services: 

a. The greater (lower) the degree of government involvement in the provision of a good or service the greater (lower) the price increases (decreases) over time, e.g., hospital and medical costs, college tuition, childcare with both large degrees of government funding/regulation and large price increases vs. software, electronics, toys, cars and clothing with both relatively less government funding/regulation and falling prices. As somebody on Twitter commented:

Blue lines = prices subject to free-market forces. Red lines = prices subject to regulatory capture by government. Food and beverages are debatable either way. Conclusion: remind me why socialism is so great again.

b. Prices for manufactured goods (cars, clothing, appliances, furniture, electronic goods, toys) have experienced large price declines over time relative to overall inflation, wages, and prices for services (education, medical care, and childcare).

c. The greater the degree of international competition for tradeable goods, the greater the decline in prices over time, e.g., toys, clothing, TVs, appliances, furniture, footwear, etc.

d. From Twitter comments this week (2022).

*Thank goodness the government doesn’t subsidize TVs or toys, or toy TVs.

*Almost every line that went up, has had some type of government involvement, while the lines going down have more to do with capitalism.

*And as always, the more regulated, the more expensive things become.

There is a big distributional impact here. Less well off people buy more blue stuff, rich people more red stuff. 

The implications for greater protection, less immigration, industrial policy, and subsidies are pretty clear. 

Update:

I have been sloppy, about one of my own pet peeves. This graph is about relative prices, not about inflation.  

 

 

Time for Supply

At Project Syndicate essay, with Jon Hartley. It's not the first, and it won't be the last on the issue! 

Now that surging inflation has refocused everyone's attention on the long-ignored supply side of the economy, the question is how best to support broad-based growth, efficiency, and innovation. The answer is not necessarily deregulation, but the need for smarter regulation is increasingly apparent – even to progressives.

STANFORD – The return of inflation is an economic cold shower. Governments can no longer hope to solve problems by throwing money at them. Economic policy must now turn its attention to supply and its cousin, economic efficiency. 

The issue is deeper than delayed goods deliveries and a year’s worth of sharp price increases. From the end of World War II to 2000, US real (inflation-adjusted) GDP per capita grew 2.3% per year, from $14,171 to $44,177 (in 2012 dollars). Americans became healthier, lived longer, reduced poverty, and paid for a much cleaner environment and a vast array of social programs. But since 2000, that post-war growth rate has fallen almost by half, to 1.4% per year. And it’s worse in Canada and Europe, where many countries have not grown at all since 2010 on a per capita basis. 

Nothing matters more for human flourishing than long-term economic growth. So, no economic trend is more worrisome than growth falling by half, especially for the well-being of the less fortunate. 

The eruption of inflation settles a long debate. Sclerotic growth is not the result of demand-side “secular stagnation,” fixable only with massive fiscal and monetary stimulus. Sclerotic growth is a supply problem. We need policies to increase the economy’s productive capacity – either directly or by reducing costs. 

How? The simplest and most important thing governments can do is to get out of the way. Byzantine regulations and capricious regulatory authorities stymie business. We do not need thoughtless deregulation, but rather smarter regulation that is simple, effective, avoids disincentives and unintended consequences, and is not distorted to protect current business and prop up regulatory empires. That means adding sunset clauses to regulations, regularly re-evaluating existing measures, and instituting a right to external appeal. 

Institute for progress

We need to be reminded occasionally that nothing matters but long-run growth, and long-run growth all comes from productivity, better knowledge of how to better serve human needs and desires.  Yet economic policy is almost all not about growth, but rather about redistribution, and in particular propping up old ways of doing things and the rents associated with them. 

Courtesy Marginal Revolution, the Institute for Progress is a noteworthy new effort to produce growth-oriented policy. Institutions are important, to spread the word and create a constituency for tending the golden goose. 

..productivity growth has been in long-term decline since the 1970s. This is supposed to be the age of ambitious infrastructure investments in the battle to fight climate change, but we can’t even build new solar plants without being vetoed by conservation groups. Hyperloops and supersonic airplanes promise to revolutionize transportation, but building a simple subway extension in NYC costs up to 15 times more per kilometer than it does in other cities around the world. ...The pace of scientific progress has been slowing.... 

(Here and elsewhere see the original for links.) Why? 

Over the last 50 years, we’ve increased the number of veto points at nearly every governmental level, failed to invest in state capacity, and raised the stakes of the debate through polarization. So it perhaps shouldn’t be a surprise that the federal government that went to the moon in 1969 botched production of simple diagnostic tests during a once-in-a-century pandemic.

But the potential is there. Maybe we are not running out of ideas after all, but merely on the edge of technical revolutions, like changing from rail to airplanes:    

...there are genuinely exciting — potentially game-changing — discoveries on the horizon. 

Accounting for the blowout / Project Syndicate

A Project Syndicate Essay. Before it moves on to climate change, inequality, and racial issues, the Fed should have to think just a little bit about the evident failure of its existing financial regulation. 

Why Isn't the Fed Doing its Job?

The nomination of new members to the US Federal Reserve Board offers an opportunity for Americans – and Congress – to reflect on the world’s most important central bank and where it is going. 

The obvious question to ask first is how the Fed blew its main mandate, which is to ensure price stability. That the Fed was totally surprised by today’s inflation indicates a fundamental failure. Surely, some institutional soul searching is called for. 

Yet, while interest-rate policies get headlines, the Fed is now most consequential as a financial regulator. Another big question, then, is whether it will use its awesome power to advance climate or social policies. For example, it could deny credit to fossil-fuel companies, demand that banks lend only to companies with certified net-zero emissions plans, or steer credit to favored alternatives. It also could decide that it will start regulating explicitly in the name of equality or racial justice, by telling banks where and to whom to lend, whom to hire and fire, and so forth. 

But before considering where the Fed’s regulation will or should go, we first need to account for the Fed’s grand failure. In 2008, the US government made a consequential decision: Financial institutions could continue to get the money they use to make risky investments largely by selling run-prone short-term debt, but a new army of regulators would judge the riskiness of the institutions’ assets. The hope was that regulators would not miss any more subprime-mortgage-size elephants on banks’ balance sheets. Yet in the ensuing decade of detailed regulation and regular scenario-based “stress tests,” the Fed’s regulatory army did not once consider, “What if there is a pandemic?” 

Weekend reads on the state of America -- and China

Two pieces stood out from some weekend internet meandering. 

Marginal Revolution points to an excellent long letter from Dan Wang on China.

A trenchant part of Dan's essay is, curiously, a few reflections on America. Not bad for living in Shanghai: 

The US, for starters, should get better at reform. The federal government has found itself unable to build simple infrastructure or coordinate an effective pandemic response. Somehow the US has evolved to become a political system in which people can dream up a hundred reasons not to do things like “build housing in growing areas” or “admit people with skills into the country.” If the US wants to win a decades-long challenge against a peer competitor, it needs to be able to improve state capacity. ...

Since the US government is incapable of structural reform, companies now employ algorithm geniuses to help people navigate the healthcare system. This sort of seventh-best solution is typical of a vetocracy. I don’t see that the US government is trying hard to reform institutions; its response is usually to make things more complex (like its healthcare legislation) or throw money at the problem. The proposed bill to increase domestic competitiveness against China, for example, doesn’t substantially fix the science funding agencies that are more concerned with style guides than science; and the infrastructure bill doesn’t seem to address root causes that make American infrastructure the most costly in the world. Congress is sending more money through bad channels.

 Stop and savor. 

What's in the reconciliation bill? A conversation with Casey Mulligan.

 A podcast discussion with Casey Mulligan. What's in the reconciliation bill? How will it work? 

Link to the podcast page, with lots of other formats. 

Yesterday Casey tweeted that he had read the entire 2,400 page bill. Casey does this sort of thing, as explained in his book "Your'e hired." I have been trying to figure out what's in it for a while. The media coverage is basically absent. (See this great Marginal Revolution post and Bloomberg column (gated, sadly) by Tyler Cowen.) I tried downloading the actual bill too, but promptly fell asleep. (Casey has some good hints on how to read it.) 

But here we are, about to embark on a huge set of new federal programs, really larger than anything since the Johnson Administration, and there is essentially no description of what they are, no debate on how they will work, and especially (my hobby horse) what incentives and disincentives they provide. Many of the previous welfare-state programs were disastrous for the supposed beneficiaries. How are we going to avoid that again? At most we talk about top line numbers. I'm a debt hawk, but if we could heal the planet, end all inequity, bring full social racial and gender justice, wipe out poverty, give every American a life of dignity, prosperity, and opportunity for a mere $3.5 trillion, I'm in. Double it. The real question is whether any of this will happen. 

Well, Casey read the bill and knows what's in it! Tune in to find out.. 

PS, I hope to get the podcast going more regularly this fall,

Update: 

A summary and review from David Henderson. 

Casey writes a detailed blog post on BBB disincentives. 

Adumbrations of FDA

Scott Alexander's Adumbrations Of Aducanumab is a great review of FDA snafus -- with deeper lessons about regulation in general. Yes the outcome is dumb, but incentives are to blame. That's important to understand if we are ever to fix this mess. 

Scott has some great ideas for fixing the FDA's incentives. The one I like best is to reduce its power. FDA approval currently means that insurance companies and the government must pay for drugs. Break that link. The FDA now either decides safe&effective vs. not-yet-proven, and makes taking any not-yet-proven drug illegal. Reduce the FDA to simply providing information about what's known about drugs. Finally, give the FDA budgetary rewards for approving drugs. Bemoaning regulatory idiocy is fun but gets us nowhere. Anything persistently busted is not the result of stupidity, it is the result of bad incentives. 

FDA, CDC and Covid

The story of the FDA in covid is a good place to start. It's well known by now, but we are now in the era of forgetting, and it is to nobody's interest to keep this memory alive. 

The countries that got through COVID the best (eg South Korea and Taiwan) controlled it through test-and-trace. This allowed them to scrape by with minimal lockdown and almost no deaths. But it only worked because they started testing and tracing really quickly - almost the moment they learned that the coronavirus existed. Could the US have done equally well?

I think yes. A bunch of laboratories, universities, and health care groups came up with COVID tests before the virus was even in the US, and were 100% ready to deploy them. 

As with vaccines, which took a weekend to create, the state of medical science is such that really there is no reason to have pandemics any more. Public policy? Well, that's stuck in the 1700s.  

But when the US declared that the coronavirus was a “public health emergency”, the FDA announced that the emergency was so grave that they were banning all coronavirus testing, so that nobody could take advantage of the emergency to peddle shoddy tests. Perhaps you might feel like this is exactly the opposite of what you should do during an emergency? This is a sure sign that you will never work for the FDA.

Climate risk to the financial system

I wrote a piece for Project Syndicate, here,  on climate financial risk.  (This resulted from a presentation on a panel at the NBER summer institute risks of financial institutions meeting, program here. There should be a video version on YouTube but I can't find it. The panel discussion was excellent. You will recognize ideas from my earlier climate finance testimony. I recycle and refine. ) I titled it "an answer in search of a question," but PS didn't like that so we have the "fallacy" title. 

The essay: 

In the United States, the Federal Reserve, the Securities and Exchange Commission, and the Department of the Treasury are gearing up to incorporate climate policy into US financial regulation, following even more audacious steps in Europe. The justification is that “climate risk” poses a danger to the financial system. But that statement is absurd. Financial regulation is being used to smuggle in climate policies that otherwise would be rejected as unpopular or ineffective.  

“Climate” means the probability distribution of the weather – the range of potential weather conditions and events, together with their associated probabilities. “Risk” means the unexpected, not changes that everyone knows are underway. And “systemic financial risk” means the possibility that the entire financial system will melt down, as nearly happened in 2008. It does not mean that someone somewhere might lose money because some asset price falls, though central bankers are swiftly enlarging their purview in that direction. 

In plain language, then, a “climate risk to the financial system” means a sudden, unexpected, large, and widespread change in the probability distribution of the weather, sufficient to cause losses that blow through equity and long-term debt cushions, provoking a system-wide run on short-term debt. This means the five- or at most ten-year horizon over which regulators can begin to assess the risks on financial institutions’ balance sheets. Loans for 2100 have not been made yet.

Such an event lies outside any climate science. Hurricanes, heat waves, droughts, and fires have never come close to causing systemic financial crises, and there is no scientifically validated possibility that their frequency and severity will change so drastically to alter this fact in the next ten years. Our modern, diversified, industrialized, service-oriented economy is not that affected by weather – even by headline-making events. Businesses and people are still moving from the cold Rust Belt to hot and hurricane-prone Texas and Florida. 

If regulators are worried even-handedly about out-of-the-box risks that endanger the financial system, the list should include wars, pandemics, cyberattacks, sovereign-debt crises, political meltdowns, and even asteroid strikes. All but the latter are more likely than climate risk. And if we are worried about flood and fire costs, perhaps we should stop subsidizing building and rebuilding in flood and fire-prone areas. 

Climate regulatory risk is slightly more plausible. Environmental regulators could turn out to be so incompetent that they damage the economy to the point of creating a systemic run. But that scenario seems far-fetched even to me. Again though, if the question is regulatory risk, then even-handed regulators should demand a wider recognition of all political and regulatory risks. Between the Biden administration’s novel interpretations of antitrust law, the previous administration’s trade policies, and the pervasive political desire to “break up big tech,” there is no shortage of regulatory danger.

To be sure, it is not impossible that some terrible climate-related event in the next ten years can provoke a systemic run, though nothing in current science or economics describes such an event. But if that is the fear, the only logical way to protect the financial system is by dramatically raising the amount of equity capital, which protects the financial system against any kind of risk. Risk measurement and technocratic regulation of climate investments, by definition, cannot protect against unknown unknowns or un-modeled “tipping points.” 

What about “transition risks” and “stranded assets?” Won’t oil and coal companies lose value in the shift to low-carbon energy? Indeed they will. But everyone already knows that. Oil and gas companies will lose more value only if the transition comes faster than expected. And legacy fossil-fuel assets are not funded by short-term debt, as mortgages were in 2008, so losses by their stockholders and bondholders do not imperil the financial system. “Financial stability” does not mean that no investor ever loses money.

Moreover, fossil fuels have always been risky. Oil prices turned negative last year, with no broader financial consequences. Coal and its stockholders have already been hammered by climate regulation, with not a hint of financial crisis.  

More broadly, in the history of technological transitions, financial problems have never come from declining industries. The stock-market crash of 2000 was not caused by losses in the typewriter, film, telegraph, and slide-rule industries. It was the slightly-ahead-of-their-time tech companies that went bust. Similarly, the stock-market crash of 1929 was not caused by plummeting demand for horse-drawn carriages. It was the new radio, movie, automobile, and electric appliance industries that collapsed.

If one is worried about the financial risks associated with the energy transition, new astronomically-valued darlings such as Tesla are the danger. The biggest financial danger is a green bubble, fueled as previous booms by government subsidies and central-bank encouragement. Today’s high-fliers are vulnerable to changing political whims and new and better technologies. If regulatory credits dry up or if hydrogen fuel cells displace batteries, Tesla is in trouble. Yet our regulators wish only to encourage investors to pile on. 

Climate financial regulation is an answer in search of a question. The point is to impose a specific set of policies that cannot pass via regular democratic lawmaking or regular environmental rulemaking, which requires at least a pretense of cost-benefit analysis.

These policies include defunding fossil fuels before replacements are in place, and subsidizing battery-powered electric cars, trains, windmills, and photovoltaics – but not nuclear, carbon capture, hydrogen, natural gas, geoengineering, or other promising technologies. But, because financial regulators are not allowed to decide where investment should go and what should be starved of funds, “climate risk to the financial system” is dreamed up and repeated until people believe it, in order to shoehorn these climate policies into financial regulators’ limited legal mandates.

Climate change and financial stability are pressing problems. They require coherent, intelligent, scientifically valid policy responses, and promptly. But climate financial regulation will not help the climate, will further politicize central banks, and will destroy their precious independence, while forcing financial companies to devise absurdly fictitious climate-risk assessments will ruin financial regulation. The next crisis will come from some other source. And our climate-obsessed regulators will once again fail utterly to anticipate it – just as a decade’s worth of stress testers never considered the possibility of a pandemic.

*****

In retrospect I should have emphasized one point more strongly. Suppose you do believe that there is a "climate risk" to the financial system, a "tipping point" that can happen in the next 5-10 years. Suppose you believe that all our forest fires and floods are the result only of climate change, and might engulf the economy in the next decades.  If so, none of the currently advocated policies will do anything about it, especially those implemented by financial regulation.  The best the most aggressive climate policies hope to do is to limit the further increase in temperature by 2100.  Cutting fossil fuels out of debt markets, printing money to buy windmill and electric car bonds, a full on ESG effort in money management ... none of this will lower carbon dioxide to pre-industrial levels in the next 10 years. None of this will stop wildfires and floods in your great-grandchildren's lifetimes. 

It follows, that if financial regulators accept even the most climate-alarmist position, and for the goal of protecting the financial system, the policy must be one of rapid adaptation. Spend billions to clear the brush that burns, to build dikes, and certainly not to rebuild crumbling condos on the sea shore.  The mantra (I listen to NPR) that each disaster is the result of climate change does not mean that any currently envisioned climate policy is the best, or even vaguely effective, way to combat the chance of such disasters in our lifetimes. Or those of our great-grandchildren. 

That simple fact does not mean we should ignore the climate, but it does mean that if you truly believe these scenarios, an immense adaptation effort must be undertaken right now. If you don't follow to that conclusion, perhaps you don't really believe that there is a climate financial risk, and this is just a subterfuge to pass policies actually aimed at year 2100 temperatures and having nothing to do with climate risks, by radically un-democratic means. Which is my point. 

Whither the Fed

I gave the UCSD economic roundtable lecture Friday June 11 on inflation and the future of the Fed. It summarizes quickly a number of themes from previous Grumpy writings, and if you enjoy videos you might find it fun. Youtube link in case the above embed does not work. 

I happened on the New York Fed website, proclaiming on its landing page that it is now

"...dedicated to understanding and finding solutions to the numerous forms of inequality that communities of color experience and working with communities in our District to address deep-seated inequities," 

in case you want documentation that the Federal Reserve is taking on inequality and racial issues. 

Slides available here. 

Why won't banks take your money?

 Banks to Companies: No More Deposits, Please, says the puzzling headline at WSJ. 

Why would bankers not want to take any amount of deposits, park them in reserves at the Fed or short term Treasury bills, charge fees and a slight interest spread, and sign up for an early tee-time at the local golf club? Sure "net interest margin" or other metrics might not look good, but money is money and more money is more money. 

The answer: 

Top of mind for many big banks is a rule requiring them to hold [sic] capital equivalent to at least 3% of all assets. Worried about the rule’s impact during the pandemic, the Fed changed the calculation in 2020 to ignore deposits the banks held at the central bank, but ended that break this March. Since then, some banks have warned the growing deposits could force them to raise more capital, or say no to deposits.

This is a fascinating little insight into the crazy world of our Fed's risk regulation. 

Cruz on crony capitalism

Senator Ted Cruz wrote a blistering Wall Street Journal Op-Ed decrying CEOs who pander to Democrats by making profoundly uninformed public statements. He announced that he will no longer take money from their corporate political action committees. And, he states

This time, we won’t look the other way on Coca-Cola’s $12 billion in back taxes owed. This time, when Major League Baseball lobbies to preserve its multibillion-dollar antitrust exception, we’ll say no thank you. This time, when Boeing asks for billions in corporate welfare, we’ll simply let the Export-Import Bank expire.

Cruz' statement is unintentionally devastating. So what about last time? 

So there it is in front of us, in writing, from a major politician. Political support, and campaign cash bought $12 billion tax breaks, antitrust exemptions, and Ex-Im subsidies. From Republicans. So much for any public policy pretense. And if those CEOs just figured out who has the power to hand out goodies now, and the Democrat's demands for public obeisance as well as cash, well, it's a lot harder to object that the CEOs fall in line.  

Vaccines and liability

I learned something from the New York Times lead editorial on Sunday. Why are we not shipping mega quantities of vaccines to countries like India? 

... as the vaccines came to market, some vaccine makers insisted on sweeping liability protections that further imperiled access for poorer countries. The United States, for example, is prohibited from selling or donating its unused doses, as Vanity Fair has reported, because the strong liability protections that drugmakers enjoy here don’t extend to other countries...

Pfizer has reportedly not only sought liability protection against all civil claims — even those that could result from the company’s own negligence — but has asked governments to put up sovereign assets, including their bank reserves, embassy buildings and military bases, as collateral against lawsuits. 

Well, you can sort of see the problem. You're a drug company. You sell a billion units of a brand new drug -- still on emergency use authorization in the US -- to, say, India. 10 people get a rare blood clot that may or may not be due to your vaccine. Local courts sue you for a gazillion dollars. Who wouldn't want liability protection? 

As the Europeans allowed trillions of GDP and quite a few lives to vanish while they haggled over a few billion in cost of vaccines, perhaps the onus on countries should be, to say, we want your vaccine, we understand it's brand new and there may be risks, we'll take them?  

The NYT is, predictably, full of bad ideas. 

A letter to Yellen

Secretary of the Treasury, and ex Federal Reserve Chair Janet Yellen recently hosted an important meeting of the Financial Stability Oversight Council.  This is the highest level body overseeing financial regulation in the US. It matters. 

Her remarks start smoothly but critically, as one expects of a habitually well-prepared pro. A lot went wrong last year, from the treasury markets to another mutual fund bailout, and so forth. Bravo, it is time to get past celebrating how another bailout blowout saved the world and see if we can avoid another one. 

And then, 

We must also look ahead, at emerging risks. [To the financial system, the FSOC's purview.] Climate change is obviously the big one.

It is an existential threat to our environment, and it poses a tremendous risk to our country’s financial stability. We know that storms will hit us with more frequency, and more intensity. We know warming temperatures might disrupt food and water supplies, leading to unrest around the world. Our financial system must be prepared for the market and credit risks of these climate-related events. But it must also be prepared for the best-possible case scenario: that we begin a rapid transition to a net-zero carbon economy, which also creates potential challenges for financial institutions and markets. On all these fronts, the Council has an important role to play, helping to coordinate regulators’ collective efforts to improve the measurement and management of climate-related risks in the financial system.

Dear.. May I still call you Janet? I have known you for 40 years, since you were kind to a young brash graduate student. In all that time you have always worked for sensible well-reasoned, quantitatively evaluated policy. I don't always agree, but you always have clear, careful and conservative (in the move-carefully sense, not the political sense) thinking behind your recommendations. 

What the heck is going on? Surely you know this is nonsense?