Fed Independence 2025

Headline: The Fed just  forced mortgage servicers  that got caught submitting "documents that were not properly notarized," among other sins, to cough up money towards principal reduction, for people unaffected by the notarization scandal, as well as to fund "nonprofit housing counseling organizations" and other policy objectives. 

Deeper question: What will the Fed look like in 2025? How long can it stay independent as it takes on more and more power, and uses that power for these kinds of political policy actions?

Act 1:  Three recent news items add up to a scary picture.

Where your money goes

Two nice graphs from the New York Times 

Comment: Now, could we please stop talking about how we need more taxes to pay for roads and bridges or to help the poor? The main function of our government is to write checks to middle-class and wealthy voters. And that's the reason its finances are in the toilet.

This means Elizabeth Warren, for example, who said a factory owner needs to pay more taxes because "you moved your goods to market on the roads the rest of us paid for; you hired workers the rest of us paid to educate; you were safe in your factory because of police forces and fire forces that the rest of us paid for." Answer: you paid for that long ago. That's not where the money is going.

Wallison on financial regulation

Peter Wallison has an important Op-Ed in the Wall Street Journal last week (AEI link) titled "Dodd-Frank and the Myth of Interconnectedness"

The chain of bankruptcies is one of the central myths of the financial crisis. A owes money to B,  B owes money to C, C owes money to D. If A fails, it wil result in a chain of bankruptcies where B, C,  and D fail too.

As Peter points out, it simply did not happen. We had a run, not a chain of bankruptcies.

The Real Trouble With the Birth-Control Mandate

(This is a Wall Street Journal Op-Ed. If you don't subscribe, there is a pdf on my webpage.)

When the administration affirmed last month that church-affiliated employers must buy health insurance that covers birth control, the outcry was instant. Critics complained that certain institutions should be exempt as a matter of religious freedom. Although the ruling was meant to be final, presidential advisers said this week that the administration might look for a compromise.

Critics are missing the larger point. Why should the Department of Health and Human Services (HHS) decree that any of us must pay for "insurance" that covers contraceptives?

Taylor's graphs

John Taylor wrote a very nice blog post, "Reassessing the recovery". He made two graphs, reproduced here. On the top you see the current recession and recovery. On the bottom you see the typical pattern, exemplified by the biggest previous postwar recession in 1982.

We usually bounce back to the trend line. Now, we're not.

The difference betwen "levels" and "growth rates" accounts for a lot of confusion in popular discussions. "Recessions" are pretty much defined as times in which GDP is declining -- negative growth rates, the level is going down. GDP stopped going down in early 2009.

Yet, as many commentators point out, if the recession is over, why does it feel so glum out there? Answer: because prosperity is measured in levels. Employment responsds to levels. 

The big macroeconoimc question for our time is this: Just why are we stuck at a much lower level? What do we need to do to get back to the trend line? Or is that trend line illusory?

There are two stories -- and I use that word advisedly.

Sargent on debt and defaults

Tom Sargent's Wall Street Journal oped is well worth reading closely. It's a very short summary of his Nobel prize speech

As readers of this blog will probably know, I think Europe should stop bailing out bondholders of Greek and other debt. (See the Euro collection and Euro tags to the right.)

"What about Alexander Hamilton?" has always been a nagging doubt.

Negative stimulus, 1946

I ran across a fascinating article, "A Post-Mortem on Transition Predictions of National Product,"  in the 1946 Journal of Political Economy, by Lawrence Klein. Klein, who would go on to create the main macroeconomic forecasting models and a Nobel Prize, was  confronting one of the first great failures of Keynesian economics:

Consumer financial protection, 1984

The Financial Times reports an amazing interview with Martin Wheatley, the "head of the UK's new consumer protection watchdog."

Investors cannot be counted on to make rational choices so regulators need to “step into their footprints” and limit or ban the sale of potentially harmful products,

Consumer financial protection, 1840

I recently read again a very nice paper by Toby Moskowitz and Effi Benmelech, "The Political Economy of Financial Regulation" which studies 19th century usury laws. Usury laws limit interest rates that can be charged for loans, supposedly to protect borrowers.

It doesn't always work out that way.

A brief parable of over-differencing

The Grumpy Economist has sat through one too many seminars with triple differenced data, 5 fixed effects and 30 willy-nilly controls. I wrote up a little note (7 pages, but too long for a blog post), relating the experience (from a Bob Lucas paper) that made me skeptical of highly processed empirical work.

The graph here shows velocity and interest rates.  You can see the nice sensible relationship.

(The graph has an important lesson for policy debates. There is a lot of puzzling why people and companies are sitting on so much cash. Well, at zero interest rates, the opportunity cost of holding cash is zero, so it's a wonder they don't hold more. This measure of velocity is tracking interest rates with exactly the historical pattern.) 

But when you run the regression, the econometrics books tell you to use first differences, and then the whole relationship falls apart. The estimated coefficient falls by a factor of 10, and a scatterplot shows no reliable relationship.  See the the note for details, but you can see in the second graph  how differencing throws out the important variation in the data. 

The perils of over differencing, too many fixed effects, too many controls, and that GLS or maximum likelihood will jump on silly implications of necessarily simplified theories are well known in principle. But a few clear parables might make people more wary in practice.  Needed: a similarly clear panel-data example.

547 pages

As reported by the Wall Street Journal, Mitt Romney's tax return was 547 pages long. If you want to know what's completely sick with our tax code, this is it.

Demographics and stock prices

Zheng Liu and Mark Spiegel at the San Francisco Fed wrote a very nice letter  on demographics and asset prices, summarizing a lot of good academic work on the question.

See the graph to the left, taken from the letter: M/O is the ratio of middle aged to old, and P/E is the stock market price-earnings ratio. 

It seems like a natural story: In the 1970s, there were relatively few prime-age savers around to buy stocks, and the prices fell. Starting in the 1980s to late 1990s, boomers entered their prime saving years, bought stocks and drove the prices up. And now that the boomers are retiring, they start selling, and watch out for prices! Zheng and Mark make a pretty discouraging forecast.

Romer on Regulation

I ran in to a lovely little paper on regulation, thinking about financial regulation, from Paul Romer.

In my thinking about financial regulation, I've been heading toward the idea that we should regulate assets, not institutions; that regulations should be few and simple; that regulations should be rules, not licenses for regulators to do whatever they want; that rights and recourse for the regulated are important limits on the abuse of even well-intentioned power; and that pre-commitment, limiting the power of regulators ex-ante to bail out ex-post is important.  That view is in an earlier blog post, and in an article in Regulation. More to come of course.

Paul comes to about the opposite conclusion, in a very thought-provoking way.

New Keynesian Stimulus

One piece of interesting economics did come up while I was looking through the stimulus blogwars.

Paul Krugman pointed to New Keynesian stimulus models in a recent post, When Some Rigor Helps.

But take an NK [New-Keynesian] model like Mike Woodford’s (pdf) — a model in which everyone maximizes given a budget constraint, in which by construction all the accounting identities are honored, and in which it is assumed that everyone perfectly anticipates future taxes and all that— and you find immediately that a temporary rise in G produces a rise in Y"...

So I guess I’d urge all the people now engaging in contorted debates about what S=I does and does not imply to read Mike first, and see whether you have any point left. 

As it happens, I've spent a lot of time reading and teaching New Keynesian models.

Stimulus and Etiquette

The stimulus wars are heating up again.

I wrote my last, and I thought best, summary blog piece "Stimulus RIP" in November 2010, (all my stimulus posts here), but a previous 2009 post seems to be behind a new outburst of blog activity. I won't get it all, but some contributors are David Glasner,  Scott Sumner, Kantoos , Brad DeLong and of course, Paul Krugman

Some response seems called for.

Romney's 15%

Romney's 15% average income tax rate is all over the news, with the usual "tax the rich" outrage.

Powell's secrets

Jim Powell wrote a nice Forbes article, "The Most Important Secret of a Prosperous Economy," filled with his usual brand of thoughtful historical detail. Two paragraphs caught my eye,

DeLong on Friedmans and Freedoms

Brad DeLong put up a post on Milton and Rose Friedman's Free to Choose so succinct, so outrageous, and so revealing, it merits breaking the "Don't respond to Brad" rule. Here it is, in its entirety:

News flash: Bernanke not clairvoyant

Last week was full of the shocking revelations in newly released Fed minutes. Bernanke and co. didn't foresee the housing crash and banking crisis! See coverage in the New York Times and Wall Street Journal.

What zero bound?

German bond yields turn negative, as reported in the Wall Street Journal.

Source: Wall Street Journal

Negative interest rates are a big puzzle. Easy stories miss the point: "flight to quality," "need for collateral," etc. Those stories don't explain why bonds are worth more than money.  There's no more quality or better collateral than cash!

So why would anyone suffer a negative rate on government bonds when they can hold cash instead?

For some of us it might make sense. Cash is clunky, dangerous and expensive to put under a mattress. Many banks now charge for the privilege of depositing. So an individual might prefer a very slightly overpriced government bond to cash.

But a bank has a better option. Why not just hold reserves? Reserves are like cash, and as safe and liquid (more so) than government bonds. I might have guessed that only people were buying these bonds. It seems I'm wrong (unconfirmed rumor) -- banks are buying and holding the bonds.

So why would a bank hold a bond at negative interest rate rather than hold reserves? Sometimes there are arcane technical, accounting or regulatory reasons, but so far nobody I've talked to has identified one here.