Is Finance Too Big?

Is finance too big? Here's a draft essay on the subject. There is a pdf on my webpage, and updates, revisions and a final version will end up there.

This came about as a "response essay" to Robin Greenwood and David Scharfstein's "The growth of modern finance" for the Journal of Economic Perspectives. That's why Robin and David are the target of a lot of criticism. But they're really just standing in for a lot of opinion that finance is "too big," in part because they did such a good and evenhanded job of synthesizing that point of view. So, sorry for picking on you, Robin and David!

I'm sure the JEP will make me cut it down and tone it down, so this is the fun first draft.


Is Finance Too Big?

John H. Cochrane [1],[2]
January 7 2013

I. Introduction

The US spends $150 billion a year on advertising and marketing[3]. $150 billion, just to trick people into buying stuff they don’t need. What a waste. 

There are 2.2 people doing medical billing for every doctor that actually sees patients, costing $360 billion[4] -- 2.4% of GDP. Talk about “too big!”

Wholesale, retail trade and transportation cost 14.6% of GDP, while all manufacturing is only 11.5% of GDP. We spend more to move stuff around than to make it! 

A while ago, my wife asked me to look at light fixtures. Have you seen how many thousands of different kinds of light fixtures there are? The excess complexity is insane. Ten ought to be plenty.

It’s ridiculous how much people overpay for brand names when they can get the generic a lot cheaper. They must be pretty naive.

Business school finance professors are horribly overpaid. Ask an anthropologist!  We must really have snowballed university administrations to get paid nearly half a million bucks, and work a grand total of 10 weeks a year, all to teach students that there is no alpha to be made in the stock market.

Did you know that Kim Kardashian gets $600,000 just to show up at a nightclub in Vegas?  How silly is that?

It’s a lot of fun to pass judgment on “social benefits,” “size,” “complexity” of industry, and “excessive compensation” of people who get paid more than we do, isn’t it? But it isn’t really that productive either.

As economists we have a structure for thinking about these questions.

More new-Keynesian paradoxes

Last week I saw Johannes Wieland's paper "Are negative supply shocks expansionary at the zero lower bound?"  A side benefit of the job market season is that we see interesting new papers like this one, and it contributed to my project of trying to better understand new-Keynesian models.

Though starting academic papers with blog quotations is usually a bad idea, Johannes starts with a great and very appropriate one,

As some of us keep trying to point out, the United States is in a liquidity trap: [...] This puts us in a world of topsy-turvy, in which many of the usual rules of economics cease to hold. Thrift leads to lower investment; wage cuts reduce employment; even higher productivity can be a bad thing. And the broken windows fallacy ceases to be a fallacy: something that forces firms to replace capital, even if that something seemingly makes them poorer, can stimulate spending and raise employment.” -Paul Krugman

I endorse this quote, because it is an accurate and pithy description of the properties of many careful new-Keynesian analyses in the academic literature.

Two cents on the trillion dollar coin, and a debt-limit schedule

The Fed and Treasury say they're not going to try the trillion-dollar coin idea to avoid the debt limit. But the episode is very revealing about how our fiscal and monetary policies work, (or don't, as the case may be), numerous misconceptions floating around, and leads to a thought on a better way to approach the same objectives, which might be a useful compromise for both sides.

I. Why the limit binds

First, just to be clear, let me clarify the playlist: 

• Debt: US government bonds, issued by the Treasury. Promises to pay for your healthcare is not "debt," and if the government reneges on that promise it's not a "default."
• Cash: Bills and coins.
• Reserves: Essentially checking accounts at the Fed. Banks may freely obtain cash in return for reserves and vice versa.We often say "the Fed prints money" when in fact what it does is to create reserves.

In the first debt-limit debate, I was initially puzzled that it was a problem at all. The "debt limit" does not include currency or reserves, though both are functionally US government debt. That seems like an unfortunate oversight:  Why can't the government just pay its bills by printing money, i.e. creating reserves? Sure, you might worry about inflation sooner or later, but this is a legal question. The government can print money to pay its bills, no?

Well, no, which is really interesting.

Birthday

Two milestones passed this week, the one year birthday of this blog, and the millionth hit. OK, I'm not in the big leagues yet, but it continues to be a lot of fun. I appreciate all of you who read, and all the comments too. Well, almost all the comments.

(Photo credit: Ty Bellitti Photography)

Managing a liquidity trap

I've been catching up on my new-Keynesian economics and found a little gem by Ivan Werning, "Managing a liquidity trap"

The policy issue is this: we're in a recession. Interest rates are zero, and can't go lower. The Fed is desperately trying to goose the economy. Lots of people (most of the recent Jackson Hole Fed conclave) are advising  "open-mouth operations," and  "managing expectations," that the key to current prosperity is for the Fed to make statements  about what it will do in the future; and these statements on their own, with no concrete action, will "increase demand" and lower today's unemployment. The Fed has been convinced, with more and more "forward guidance" as part of its strategy.  For example, the latest FOMC statement made history by promising zero interest rates as long as unemployment stays above 6 and a half percent and inflation below two and a half.

Does any of this make any sense?

Fiscal cronyism

I thought of a nice thing to say about the "fiscal cliff" outcome. At least the tax rates are "permanent." We will be spared the annual last-minute crisis when the "Bush tax cuts expire."  Further tax increases will take a new initiative, not a scheduled cliff.

The exact opposite happened on the special-deal side: all the "temporary" special deals got extended for a year, a recipe to tell lobbyists they'd better stay on Congress' and the Administration's good side through next year, and a lovely way for long-run budget numbers not to reflect actual spending.

Daniel Henninger's excellent Wall Street Journal column covered this aspect well:

The section titled "Business Tax Extenders" gets ink because it is so ripe for "Daily Show" ridicule.

Fiscal cliff video

I did a "Chicago tonight" segment on the fiscal cliff,


The other guest, Carl Tannenbaum, is a good friend as well as a thoughtful economist. We went to high school together. It was a pleasant surprise to run in to him in the foyer of WTTW's studios.

The intro segment is worth watching too. "Chicago tonight's" producers wisely got a real tax lawyer to explain what the "cliff" is all about.


How nice to start with a quick review of strategies that "the rich" will use to avoid the new taxes.

One year from now, the studies will start rolling in (I hope) documenting how much extra revenue the fiscal cliff tax hikes actually collected from their targets. My bet: less than half of the $60 billion advertised. I'll be surprised if it's positive, actually.

Who won the fiscal cliff negotiations? Democrats? Republicans? VP Joe Biden? No. Tax lawyers, accountants, and lobbyists.

In case you think any of this had to do with deficits, I sign off today with a lovely graph from a great piece by Yuval Levin:

And it will be less than that. Yuval uses the CBO forecasts, which assume rich people don't watch "Chicago tonight" and talk to their tax lawyers.

Local news: Food trucks and movie theaters

Two fun bits of local (Chicago) news, lest you think that over regulation, incumbent protection, rent-gathering and general idiocy reign only in Washington. Food trucks and movie theaters.

Revolving door

The Wall Street Journal reveals a good way to make money in the new US economy: Work for agencies like the CFTC who get to write huge complex and vague rules for financial companies, with lots of discretion and supervision, then go work for the companies who have to comply with said rules.

A few tidbits from "Hot Commodities: CFTC Staffers" (which is a news story, not an editorial)

Dodd-Frank has prompted strong demand for staffers from the Commodity Futures Trading Commission. The law gave the agency broad new responsibilities to write rules for complex derivatives called swaps that had been largely unregulated. Many rules already are in place, while others will take effect next year. The new swaps rules have swept many more financial firms under the agency's jurisdiction, boosting demand for even midlevel staffers with just a few years' experience.

The Times on Taxes

The New York Times' Sunday lead editorial (12/30) is simply breathtaking. The title is "Why the economy needs tax reform." It starts well,

Over the next four years, tax reform, done right, could be a cure for much of what ails the economy...

OK, say I, the sun is out, the birds are chirping, my coffee is hot, and for once I'm going to read a sensible editorial from the Times, pointing out what we all agree on, that our tax system is horrendously chaotic, corrupt, and badly in need of reform. Let's go -- lower marginal rates, broaden the base, simplify the code.

That mood lasts all of one sentence.

Higher taxes,...

Words matter. "Reform" twice, followed by paragraphs of "higher taxes," with no actual "reform" in sight. The Times is embarking on an Orwellian mission to appropriate the word "reform" to mean "higher taxes" not "fix the system."

Let's be specific. What is the Times' idea of tax "reform?"

Benefits trap art

Two charts from the UK, admittedly sprayed with too much chartjunk, but illustrating the poverty trap in Britain. (A previous post  on high marginal tax rates for low income people has more charts like this.)

Most of UK benefits are not time-limited, so people get stuck for life, and then for generations.

Fiscal cliff or fiscal molehill?

Four thoughts, reflecting my frustrations with the "fiscal cliff" debate. 

1. Recession

How terrible will it be if we go over the cliff?

Bad, but for all the wrong reasons. If you, like me, didn't think that "stimulus" from government spending raised GDP in the recession, you can't complain that less government spending will cause a new recession now. The CBO's projections of recession are entirely Keynesian. Pay them heed if you still think the key to prosperity is for the government to borrow money and blow it.

The Fed's great experiment

So now you have it. QE4. The Fed will buy $85 billion of long term government bonds and mortgage backed securities, printing $85 billion per month of new money (reserves, really) to do it. That's $1 trillion a year, about the same size as the entire Federal deficit. It's substantially more each year than the much maligned $800 billion "stimulus." Graph to the left purloined from John Taylor to dramatize the situation.

In addition, the Fed's open market committee promises to

"..keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." [Whatever "anchored" means.] 

This is a grand experiment indeed. We will test a few theories.

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here's the problem. Why not just let Greece default?" is usually answered with "because then all the banks fail and Greece goes even further down the toilet." (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.

Billing codes

A while ago, an acquaintance saw her dermatologist for an annual check. She said, "oh, by the way, take a look at the place on my foot where we removed a wart a while ago." The doctor looked at her foot, said everything is fine, then finished the exam. Checking the bill, there was a $400 extra charge for the wart examination!

This nice audio story from NPRs "third coast festival"  tells the story of billing codes. Answer: As insurers and medicare/medicaid reduce payment for services, doctors respond by writing up every billing code they legally can. There are whole conferences devoted to billing code maximization. It's a lovely unintended-consequences story. Good luck with that "cost control."

The piece quotes the Institute of Medicine that there are 2.2 people doing billing for every doctor, at a $360 billion dollar cost. I couldn't find the source of these numbers. If any of you can, post a comment.

Of course, being NPR, the program leaves the impression that all this will be fixed in our brave new world of the ACA. But it wasn't even that heavy handed on the point. Perhaps experience is gaining on hope.

Buffett Math

Warren Buffett, New York Times on November 25th 2012:

Suppose that an investor you admire and trust comes to you with an investment idea. “This is a good one,” he says enthusiastically. “I’m in it, and I think you should be, too.”

Would your reply possibly be this? “Well, it all depends on what my tax rate will be on the gain you’re saying we’re going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent.” Only in Grover Norquist’s imagination does such a response exist.

MBA final exam question: Explain the mistake in this paragraph.

Truth stranger than fiction?

From the New York Times. I checked, it really is not from the Onion. 

WASHINGTON — House Republicans said on Thursday that Treasury Secretary Timothy F. Geithner presented the House speaker, John A. Boehner, a detailed proposal to avert the year-end fiscal crisis with $1.6 trillion in tax increases over 10 years, an immediate new round of stimulus spending, home mortgage refinancing and a permanent end to Congressional control over statutory borrowing limits.

...In exchange for locking in the $1.6 trillion in added revenues, President Obama embraced $400 billion in savings from Medicare and other entitlements, to be worked out next year, with no guarantees.

The upfront tax increases in the proposal go beyond what Senate Democrats were able to pass earlier this year. Tax rates would go up for higher-income earners, as in the Senate bill, but Mr. Obama wants their dividends to be taxed as ordinary income, something the Senate did not approve. He also wants the estate tax to be levied at 45 percent on inheritances over $3.5 million, a step several Democratic senators balked at. The Senate bill made no changes to the estate tax, which currently taxes inheritances over $5 million at 35 percent.

Meanwhile, Costco is in the news, for borrowing $3 billion dollars, and paying it out as a special dividend before dividend taxes rise.  Stock rose 6%. Tax arbitrage is so cool.

Experimental evidence on the effect of taxes

Much of our "fiscal cliff" debate revolves around the incentive effects of raising marginal taxes on high incomes. High tax advocates used to say that taxes won't hurt growth that much, and advocated them for other reasons.  Now they are advocating that even a 91% federal income tax rate, on top of state, sales, etc, as we had in the 1950s, (not counting all the loopholes!) will actually be good for the economy and also raise lots of revenue.

This seems to me like magical thinking, and a great testament to how people can persuade themselves of anything if it suits the partisan passion of the moment.  But wouldn't it be nice if someone would run an experiment for us?

Fortunately, Europe has been running a very useful set of experiments on what happens if you address yawning deficits with high income, wealth and property taxes. Which brings me to a report from the Telegraph

Almost two-thirds of the country’s million-pound earners disappeared from Britain after the introduction of the 50p (percent) top rate of tax, figures have disclosed.

Taxes and cliffs

(Update: John Batchelor show radio interview on this blog post)

The whole tax debate is supremely frustrating to anyone who survived econ 1.

The ill effects of taxation -- the "distortions" -- depend on the total, marginal rate including transfers. If I earn an extra dollar, how much more stuff do I get, or how much more of someone else's services can I receive? That calculation has to include all taxes, federal, payroll, state, local, sales, excise, etc. and phaseouts.

And, if you receive a benefit from the government that phases out with income, so every dollar of income above (say) $30,000 reduces your benefit by 50 cents, then you face a 50 percent marginal tax rate even if you pay no "taxes" at all. Taxes and benefits -- both in level and on the margin -- need to be considered together.
 
I've been looking for good calculations of marginal rates.  The CBO has just issued a nice report titled "Effective Marginal Tax Rates for Low- and Moderate-Income Workers" that begins (begins!) to shed some light on the right question.  Here's one important graph, titled "Marginal Tax Rates for a Hypothetical Single Parent with One Child, by Earnings, in 2012";

Happy Thanksgiving

By Eric Cochrane (who also drew the grumpy economist). More here