Economics and...

Does this blog still work?

2011-01-03T12:34:00.001-05:00

It certainly seems to be functioning as an effective spam collector.

Maybe I should actually try posting something again.

Satan and the G-16: A Sacrilegious Rant and a (Modest?) Proposal

2009-03-14T11:53:00.002-04:00

It appears now that the G-20 intend to make their compromise with the devil. That’s pretty much inevitable, since the devil is one of them. When I say the devil, I am of course referring to the nation that invented the automobile (hint, President Obama: not the US). It also happens to be the nation that invented chemical warfare and the Final Solution. (What kind of a rant would this be if I respected Godwin’s Law?) I curse Comrade Gorbachev for countenancing the demolition of the Berlin wall. It is clear now that, despite having repented, with apparent sincerity, of its earlier sins, Germany is fundamentally evil. And right now I’m imagining Angela Merkel with horns and a pitchfork.

The devil, as I said, is one of them. It might be more accurate to say that the devil is four of them. Euroland, which is counted independently as one of the G-20, is entirely under the sway of the forces of darkness. France and Italy sold their souls long ago and have little chance of redemption. If I had my way, the remainder – call them the G-16 – would redeem their own souls and let continental Europe perish in fire and brimstone.

I would have the G-16 agree on a set of fixed exchange rates against the Euro. (And if China wants a cheap Yuan, I say, so be it. Let’s see how long it takes Premier Wen to figure out that he doesn’t have luxury of mistrusting US assets.) With interest rates at or near zero, the alternative to a fixed exchange rate regime among the G-16 is a regime of pointless competitive devaluation – much like the mercantilism of olden time. Nobody wins that way. Fixed exchange rates are the way to go, and while we’re at it, we can solve the “N-th country problem” by making Euroland the N-th country. Making Euroland the N-th country on more than generous terms of exchange. Indeed, let us say more than more than generous terms.

Yes, if the Europeans want a hard currency, let them have it. Let them have a currency so hard it will break their skulls. It’s a policy once known as “beggar thy neighbor,” and our neighbors between the Mediterranean and the North Sea are begging to be beggared.

But Keynes did die for everyone’s sins, and I suggest we hold out an offer of redemption to any European country that will repent and accept John Maynard as its personal savior. Set a (temptingly ungenerous) exchange rate against the Euro for each of the individual European currencies, and agree to collectively continue defending that exchange rate for, say, 7 years, if the sinner will stop worshiping the Golden Calf.

I remember with fondness the French Franc and the Italian Lira. I remember the picturesque bills. I remember (indeed, I have preserved some relics) the varied and beautiful coins. I remember, as recently as 2002, going to a grocery store in Spain, wondering why the prices looked so high, and realizing that the prices were in pesetas rather than euro cents. I remember. I remember the Garden.

Lost. It is lost. Shall not we assert the faith that it may be regained?

Even Worse than Paul Krugman Imagines?

2009-02-16T18:39:00.001-05:00

Reading Karl Smith’s comment on my previous entry, I started to think about the implications of rational expectations in the context of potential deflation. I’m thinking of a model like “Rational Expectations meets Calvo Pricing meets the Keynesian Multiplier meets the Mundell-Tobin Effect.” It goes something like this:

Start out imagining that prices are stable. Then introduce the expectation of an output gap (like the output gap that the CBO expects). An output gap implies that actual (sticky) prices are above equilibrium (flexible) prices. As more cohorts adjust their prices toward equilibrium levels, actual prices will fall. If you expect actual prices to fall, you have a disincentive from investing, because you have to pay today’s sticky prices for your capital goods, but you will only be able to sell your product at tomorrow’s (lower) flexible prices. So investment will be lower than it otherwise would be. And because of the multiplier effect, consumption will be lower than it otherwise would be.

So overall demand will be significantly lower than it otherwise would be. Therefore equilibrium prices will be even lower. Therefore we have to anticipate an even greater rate of deflation. Therefore we have to anticipate an even larger disincentive from investment, which implies an even lower level of investment, which implies an even lower level of consumption, which implies even less demand, which implies even lower equilibrium prices, which implies even faster deflation, which implies an even greater disincentive from investment, and so on. And all the “so on” is something that, if we have rational expectations, we will immediately anticipate.

Without actually writing down a model (which I’m not going to do), I can’t say for sure whether there will be an equilibrium, but if there is one, I’m pretty sure it is really, really, really ugly. My intuition says that, in an economy without a public sector or a foreign sector, there will normally be no equilibrium, and all production will simply cease.

If you throw in a government, then you can presumably have an equilibrium even without any private investment, so the economy won’t grind completely to a halt, but it will sure look pretty awful. Although I wonder: if the process of selling requires holding inventories, then it requires some investment. (Technically, it requires a level of investment that may not be positive but that can still be reduced if there are incentives to reduce it.) If the disincentive to investment rises without bound, then there will be no incentive to hold inventories, and production will still cease, even with public sector demand.

I would guess that someone has already done this sort of model more rigorously, and I don’t know what the conclusions were. But I would guess that they were quite unpleasant.

What happens to the inflation when the output gap is zero?

2009-02-15T21:50:00.003-05:00

In a blog post a couple of weeks ago, Paul Krugman presents a scatterplot of the change in the inflation rate (y) as a function of the output gap (x), with the following regression line:

y = 0.5228 x - 0.4739

I'm puzzled as to why he includes a constant term in this regression. (Maybe he was using graphics software that won't do a no-constant fit?) If you take the regression line at face value, it means that the inflation rate is predicted to fall by almost half a percentage point each year when the output gap is zero. It also means that the economy must run nearly a full percentage point above potential in order to prevent the inflation rate from falling. That doesn't make any sense.

The sensible way to do the fit is to constrain the constant term to zero (which makes the math a lot easier if you're doing the fit by hand, but some software insists on doing things the hard way even when it doesn't make sense).

It turns out it doesn't make much difference in the conclusion: the slope of the line is still approximately 0.5, and in the relevant region (with output gap above 6 percent) the intercept is not of much relative consequence. But I would have found the whole thing more convincing if the plot had displayed a reasonable regression line to begin with. When you show a line that implies that the inflation rate declines even under normal conditions, it's not that impressive when you conclude that it will decline too much under unusual conditions.

UPDATE: Paul Krugman responds. His main point is that the IMF's definition of potential output doesn't require that the inflation rate be constant when actual output equals potential (i.e. when the gap is zero). So now I understand that the IMF's construction doesn't have that property. But I'm having trouble understanding the theoretical meaning of that construction. Doesn't the IMF's filter amount to an empirical way of making a guess at a concept that still should have that property theoretically?

I suppose I can understand that you don't want to force a constraint on the guess after it has already been made. (See Prof. Kurgman's point about circular reasoning.) But the chart still doesn't look right to me. Since the CBO's potential output concept does imply stable inflation at the zero point, how can you plug the CBO's gap forecast into the IMF's gap equation and get a meaningful result? (Well, OK, the result is meaningful for our purposes, because the fitted line passes close enough to the origin to give approximately the right result, to at least the level of precision necessary for the original point about deflation risk, and because the two methods for estimating the output gap lead to reasonably similar results for the US historically -- again, given that we don't really need much precision.) Under the circumstances, since we're mixing two different concepts anyhow, it's an arbitrary decision whether to impose the zero constraint, and I think the chart would look prettier if the line went through the origin. (I suppose that's a matter of personal taste.)

I also don't like the idea of using a filter that needs to know the whole series before it can do the smoothing (which IIRC is the case with the Hodrick-Prescott filter used by the IMF). It seems to me there is still a bit of circular reasoning involved, or at least, that you're constructing a fake data series that can't necessarily be expected to have the same properties in real time as it does with benefit of hindsight. I suppose if I were doing this, and if I wanted to keep the T's crossed &c., I would avoid the CBO's gap forecasts entirely and just use raw GDP. Then I could determine historical potential output by putting the data through a one-directional filter which I could then apply to the CBO's forecasts. But it's still unclear whether the fitted line should be constrained to have a zero intercept. It seems to me, the only reason to interpret the fitted relationship as a structural one is that we have a theory wherein such a relationship exists. And in the theory, as I understand it, the line does have to pass through the origin.

Pork is Essential for Good Health

2009-02-06T13:36:00.003-05:00

Yeah, it's not just "good for you"

Here's how things stand: the stimulus bill is way too small, it's floundering in the Senate, and we stand possibly on the edge of a deflationary abyss.

Solution: find, say, the 5 most wavering Republican senators and offer them each $100 billion worth of pork. (2 isn't enough because 1 or 2 might defect and some Democrats might defect also -- although it's kind of hard to imagine a Democrat joining a Republican filibuster under the circumstances),

That solves both problems: the stimulus bill will be big enough (if perhaps less evenly distributed in its impact than one might hope -- but multiplier effects will spread out over space), and it will survive a cloture vote.

Problem solved. No depression. Happy days are here again.

Of course, it ain't gonna happen, so I still like long Treasuries.

Time for a Price Level Target, and a Damned High One!

2009-02-06T10:00:00.003-05:00

If you believe in a NAIRU, or anything remotely like a NAIRU or an accelerationist Phillips curve, the prognosis for prices is looking increasingly ugly. For those who believe confidently in such a Phillips curve and accept historical estimates of the parameters, deflation is now a certainty, and severe deflation is a strong possibility. Even among those who don't believe in a Phillips curve, deflation should be considered at least a serious possibility, and the danger of a deflationary spiral should not be ignored.

It's time to stop worrying about policies that "may cause inflation in the long run" and to embrace such policies specifically because they may -- and hopefully will -- cause inflation. Markets are desperately in need of "shock and awe," and the Fed can provide that shock by setting a long-run price level target much higher than anything previously considered reasonable. I would recommend a target representing an average rate of inflation of 6% over the next 5 years and 5% over the subsequent 5 years. The Fed could also set longer range price targets that represent lower inflation rates thereafter (assuming the earlier targets are achieved): say 4% from 2019 to 2024 and 3% thereafter. (Experience has now made clear that 2% was too low -- too close to zero -- for a long-run target during normal times.)

The point of using price level targets is that, the worse things get, the more inflation the Fed will promise for the future. And the more inflation it promises for the future (assuming markets believe those promises), the lower will be longer term real interest rates at any give level of nominal rates. If the Fed can induce such an expectation, it will then be able to provide a more dramatic stimulus at just the right time by setting real rates that are significantly negative. (If necessary, the Fed can set longer-term real rates by buying sufficient quantities of longer term securities, or by having the Treasury retire such securities.)

Again, "dangerous policies" that "may be highly inflationary in the long run" are just the policies that our leaders should be embracing at this moment, precisely because those policies may -- and hopefully will -- be inflationary in the long run. So if the Fed buys lower quality securities on which it risks having to take losses, let it say, "It is our great hope, in the event that economic weakness prevents the price level from approaching our target, that we may have the opportunity to take large losses on these securities and to make up those losses by creating more base money. Only by taking such losses can we implement the 'helicopter drop' that may be necessary." And if the Fed should expand the monetary base dramatically in the hope of encouraging bank lending, and detractors should argue that this policy is reckless because the Fed will need to withdraw that money later to prevent inflation and may not be willing to do so, let the Fed respond, "It is not our intention to withdraw that money later, unless the price level should threaten to rise significantly above our target. Should the inflation rate over the next few years prove too low, it is our intention to resist steadfastly any pressure to avoid the very high inflation rates that will then be necessary to achieve our target."

Let's be quite clear about the arithmetic here. If the average inflation rate over the next 5 years should be zero -- which in the absence of policies such as those I advocate above, would be a very reasonable forecast, and in the presence of such policies would still not be an unreasonable one -- the Fed will of course miss its 5-year target by a dramatic margin. But the 10-year target will remain. The arithmetic would then require an 11% inflation rate over those next 5 years, in order to meet that target. That is the promise that the Fed must make for the future in order to achieve the vital goal of producing very low real interest rates today. And as for those who say that 11% is too much, even if they be 99% of the population, to my mind they are all traitors, enemies of the United States and of the world, and if I had my way, they would all be hanged!

Their intentions are good, perhaps, but we must not let such foolishness lead us down the road to Hell.

Irrational Policy

2009-01-11T20:48:00.002-05:00

Following up on my last post concerning Nick Rowe's application of rational expectations to public policy: it occurs to me that the way to look for evidence of policy effectiveness is to find cases where policy was, in retrospect, irrational. In other words, look for cases where policymakers were trying to achieve objectives that, in the light of later economic thought, were bad ideas in the first place. Then look at whether they succeeded in achieving those objectives.

How exactly one would go about this econometrically I have no idea, but there is at least one obvious case study, which (if you're a macroeconomist) you have probably already thought of. According to the popular story (which I'm not entirely sure is true), the boom of the late 1960's was partly a deliberate result of policy. Today's economists tend to see such booms as a bad idea, because booms (so today's theory teaches) ratchet up inflation expectations. But the concept of ratcheting up inflation expectations was virtually unknown in the 1960's. So by today's standards, the policies of the 1960's were irrational. If you believe that story, then it is at least one data point in support of the hypothesis that policy is effective.

Rational Policy

2009-01-11T19:40:00.004-05:00

Why is it that so many economists assume that private agents are rational but policymakers are irrational?

Breaking with that rather silly custom, Nick Rowe (hat tip: Mark Thoma) applies the rational expectations concept to policymakers and reaches the conclusion that we will never be able to find evidence of policy effectiveness, even if policies are actually quite effective.

One way to think about it, perhaps, is that all we observe in the data are the effects of policy mistakes. We cannot observe policy successes because they are negative events -- non-recession, non-inflation, etc. Only if policymakers were irrational would their "successes" -- the success of perverse policies at producing perverse effects -- correspond to positive events like recessions and inflation, so that we could find correlations between policy measures and outcomes.

To be more precise, any unusual events (recessions, inflations, etc.) that we see in the data must have been unpredictable; otherwise policymakers would have predicted and avoided them. But if they were unpredictable, that means they couldn't have been correlated with any variable that is supposed to measure policy; otherwise policymakers could have observed that variable and predicted and avoided the unusual event.

I made a similar point a couple of years ago: the inability of economists to forecast recessions is actually a point in favor of the economics profession, because it means that economists who guide public policy are doing their job well and avoiding all the predictable recessions.

Snarking Bloomberg

2008-12-18T12:01:00.003-05:00

A headline on Bloomberg:

Fed Loans Guided by Raters Grading Subprime Debt AAA

Oh, my God! You mean the Fed is actually relying on ratings provided by major ratings agencies? Can you imagine such a thing? And did you know there are homosexuals in Iran? Shocking, isn't it? Hard to believe, but it's true.

Seriously, dude, this is not news! It would be fine if you labeled it as commentary and called it something like, "Why is the Fed Relying on Raters Who Graded Subprime Debt AAA?" There is a good case to be made that the Fed should be doing its own credit research rather than relying on agencies that have both conflicts of interest and abysmal recent records. And someone else can perhaps counterargue about the dangers of allowing public institutions to pick private sector winners. Whatever. It's all very interesting, but it's not news.

Krugman on Steinbrueck

2008-12-11T15:22:00.002-05:00

If I were a currency trader, I'd be selling Euros.

Phillips Curve Presages Deflation

2008-12-07T14:09:00.002-05:00

Back of the envelope analysis:

UE rate is now 6.7%.
Almost certain to rise over next couple of months.
Probably at 7% early in '09.

The most optimistic estimates have recession ending about halfway thru '09.
Stimulus program heavy on public works will be slow to implement.

In recent recessions, UE has continued to rise for at least a year afterward.
So a fairly optimistic scenario would have UE rising to 8% by YE '09 and staying there for a year.
That would give average UE around 7.5% for '09 and 8.0% for '10.

Typical estimates put NAIRU at 5%.
So UE gap is 2.5% for '09, 3% for '10.

Typical Phillips curve coefficient is around 0.5
which implies inflation rate will fall by 1.25% in '09
and an additional 1.5% in '10
and continue to fall.

Current inflation rate is around 2%

You do the math

I’m with Mephistopheles

2008-12-03T13:46:00.002-05:00

Paul Krugman makes the case for deliberately providing too much of an economic stimulus. Here I want to examine the counter-case, for which I think there is a valid argument, although it doesn’t seem to be the argument that anyone is actually making. In the end, though, I agree with Professor Krugman: too much is better than too little.

Here’s the thing, though: there is one big advantage in doing too little economic stimulus. I mean, doing some, doing a significant amount, but not quite enough. The advantage (as I have argued in many of my recent posts) is that it doesn’t cost anything, because it can be financed with seignorage.

Professor Krugman makes the case that, from the point of view of the condition of the economy – the tradeoff between output and inflation, which is what macroeconomists usually care about – it is better to do too much, because, if you do too much, the Fed has the power to undo the excess by raising interest rates (whereas, if you do too little, there is nothing the Fed can do about it, since we’re in a liquidity trap). But as most people writing for the public acknowledge (or insist), there is more to care about than the condition of the economy. There is also the condition of the government’s finances.

As far as the government’s finances are concerned, it is not just a bad idea to do too much; it is a bad idea to do enough. As long as you don’t do enough, standard textbook macroeconomic theory (at least the Keynesian kind, which is the one most influential among economic forecasters) says that there will be disinflationary, and ultimately deflationary, pressure. It’s a pretty simple point of logic. “Doing enough” is defined as getting the economy on a track where the unemployment rate will go down to the NAIRU (or possibly lower, if deflation takes hold and we are trying to reverse it). What other definition could there be? Then by definition of the NAIRU (the “non-accelerating inflation rate of unemployment,” which, if looked at from the other direction, is the non-decelerating inflation rate of unemployment, or eventually the non-accelerating deflation rate of unemployment), the inflation rate will tend to keep falling. Therefore, the Fed can keep creating money, financing the Treasury, and there will be no inflation (or any other deleterious effects that I can think of).

Once you do enough, not only does the government have to start doing real borrowing to finance its deficit; it also has to pay real interest on the outstanding debt. The government is like a monopolist facing a kinked demand curve. As long as you stay below the kink, the more you produce, the better. But as soon as you get to the kink, all Hell breaks loose. Not only are you unable to sell your marginal “new” products for a profitable price; the price of your inframarginal “old” products starts to go down too.

This puts us in a position rather like Goethe’s Faust. (I’ve only read selected passages, and those in very loose translation, so I’m relying on someone else’s analysis here, and probably an inaccurate memory even of that.) Faust is granted unlimited knowledge, until the point where he can say it is finally enough, that he has reached the culmination of human experience. At that point his soul belongs to the Devil. Similarly we are granted unlimited economic stimulus, until the point where we can say it is finally enough. At that point we are damned to Eternal Debt.

But as I argued in an earlier post, even with a debt-financed stimulus, we have a net free lunch, in the same sense that Ricardians argue that international trade provides a net free lunch. With the stimulus, there is more produced today than there would otherwise be, and at no point in the future will production have to be reduced in order to pay for the increased production today. There is unambiguously more. There may be issues about distribution, as there are with trade, but overall there is unambiguously more. Perhaps the current generation benefits at the expense of future generations, but the current generation gains more than the future generation loses.

I want to say one other thing. Even with the biggest fiscal stimulus anyone can imagine, our debt-to-GDP ratio will still end up lower than it was at the end of World War II. As I recall, that situation didn’t work out too badly. In fact, as a representative of the Future Generations that were affected by that debt – a representative who has a self-defrosting refrigerator-freezer, an automatic washing machine and dryer, a dishwasher, an air conditioner, a flat-screen color television set, a VCR/DVD player, several personal computers, an air-conditioned car with automatic transmission and power brakes that gets 35 MPG on unleaded gasoline, a blackberry, wireless internet access, immunity to polio, the ability to make a living without putting my pants on, and the opportunity to go to sleep after dusk in New York and wake up before sunrise in London despite the time difference – I would like to thank our grandparents for choosing damnation. Hell doesn’t really seem all that bad.

And in Goethe’s version, doesn’t Faust end up going to Heaven?

My Fantasy

2008-12-02T20:59:00.002-05:00

As a postscript to my last two blog entries, I want to imagine a possibility.

Suppose that the Treasury were to retire all its outstanding long-term debt, and suppose that the Fed were to buy enough of its short-term debt to keep the interest rate at zero. And suppose this were all done without causing inflation. I realize, for institutional reasons, this is all highly unlikely to happen, and it is also somewhat unlikely for economic reasons. But it isn’t inconceivable. In fact, leaving aside the institutional issues, I’d give maybe a 25% chance that it’s economically possible today, provided that the fiscal stimulus is not large enough (which is likely to be true in any case). You can disagree, but anyhow, this is only a fantasy, and I’m pretty sure I can get quite a few reputable economists to agree that my suppositions are far from inconceivable, economically speaking.

So here’s my fantasy:


Federal Budget, FY 2010

National Defense and Homeland Security  $730,213,476,219.56
Domestic Discretionary Spending         $773,154,217,326.40
Social Security                         $653,207,125,217.23
Medicare                                $417,316,224,327.01
Other Entitlements                      $615,222,143,177.03
Interest on the National Debt                         $0.00

OK, it’s only a fantasy. But as fantasies go, I think I’ve got a better shot at this than at dating Angelina Jolie. Or Isobel Wren, for that matter.

Behold the Power of Seignorage

2008-12-02T10:49:00.001-05:00

For Sepetmber 2008, the monetary base was reported at $903.5 billion. For October, it was reported at $1.1285 trillion. That's an increase of $225 billion. That's how much money the Fed created directly in one month. A couple of months of that would be enough to finance last year's federal deficit. Three or four months would be enough to finance this year's likely deficit, including the first half of the TARP.

Granted, not all the money was actually used to finance the federal deficit. Much of it was used for even more "inflationary" purposes, such as emergency lending to banks. But the money was created, and it could have been used to finance the federal deficit. And if the Fed keeps creating money at anywhere near that rate, chances are that the portion created by buying T-bills and other Treasury securities will be enough to finance the current deficit, even if that deficit is larger than we expect.

And yet not many people seem to be worried about inflation. TIPS are selling at historically high yields relative to nominal Treasuries. Commodity prices are crashing. And the great debate of the time is about whether we will experience deflation.

Yes, Virginia, there is...

Treasury Finance Policy

2008-12-01T22:43:00.005-05:00

Just a quick thought. Ben Bernanke suggested today that the Fed might start buying longer maturity Treasury securities now that it has done about all it can at the short end of the yield curve. Sounds like a good idea, but here's my question: If reducing yields on longer-term Treasuries is a desirable policy objective (and I think it is), then why is the Treasury still selling the damn things?

Granted, the Fed may ultimately need to buy even more than the Treasury is currently issuing, but wouldn't the first step, before having the Fed do something unconventional, be for the Treasury to shift its financing dramatically toward the shorter maturities? That would put downward pressure on longer-term yields and upward pressure on short-term yields, which the Fed could then relieve by buying more of them and bringing the yield back down to zero. (In other words, the Fed would do what it normally does but would have the chance to do more of it.)

From the public's point of view, it should be exactly equivalent. Under the policy Chairman Bernanke is suggesting, the Fed buys longer-term Treasuries, and it is just as if they had never been issued, while the additional short-term T-bills don't get issued in the first place. Under the policy I'm suggesting, the longer-term Treasuries don't get issued in the first place, and the Fed buys the additional short-term T-bills, so it is just as if they had never been issued.

I'll anticipate the answer and say that the availability of a certain amount of on-the-run Treasuries is important to the proper functioning of markets, so the Treasury doesn't want to stop selling them altogether. But it could reduce the size of its issues. And it could buy back some of its own securities on the open market. If the Fed confines itself to buying short-term T-bills, that would leave it more flexibility in the future if it should become necessary to withdraw some of the base money it is now creating.

UPDATE: People don't seem to be getting the point that these policies are equivalent. A shift to shorter-term financing by the Treasury would not put the Treasury at any greater risk (with respect to the need to refinance at possibly higher future interest rates) than would the Fed's contemplated policy of buying longer-term Treasuries. If the Fed buys the new T-bills (which it would, unless the economy starts to recover, in which case the Treasury could shift back to longer-term financing), the Treasury may never have to pay back or refinance the money at all. Possibly it would have to refinance, if the Fed ends up selling the T-bills (instead of rolling them over) to slow down the economy later on. But in that case, it's just a question of where the government takes the loss: if the original strategy was for the Fed to buy longer-term bonds, then the Fed would be liquidating those bonds at a loss, the loss would pass through into the Treasury, and the Treasury would have to borrow the money to make up the loss; if the original strategy was for the Treasury to shorten its financing term, then the Treasury would have to borrow the same money to refinance the expiring T-bills.

You might say that either one is bad policy for the same reason. I can appreciate the logic of that argument, but then what would you do to revive the economy? You can try a fiscal stimulus, but then the government has to "borrow" that money, so it's potentially on the hook for that repayment. (Again, though, it may not ever have to pay the money back, if the Fed finances it.) You can have the Fed buy some other kind of asset, such as agency securities, but if the securities are fully guaranteed, that's pretty much the same as buying longer-term Treasuries, and if they aren't fully guaranteed, then the Fed is taking a risk that passes through to the Treasury. You could argue that the Fed should take that risk anyhow, but that is similarly equivalent to having the Treasury take the risk (for example, by fully guaranteeing the assets). There's just no way that the government can both revive the economy and get complete assurance of not having to refinance for 30 years. That's the bad news. The good news is that there's a pretty good chance that the government would never have to refinance.

Not in Kansas Any More

2008-11-30T17:46:00.003-05:00

I put together a series for commodity prices as measured by various CRB indexes. Since there have been a couple of new CRB indexes introduced at certain times, and the new indexes have each eventually supplanted the earlier version, I patched together a series going back to 1950 using the "current" version of the CRB index at each point in time. (I'm looking at closing prices at the end of each month.)

Over 58 57 years, from the beginning of ~~1950~~ 1951 through the end of 2007 (and through the first half of 2008), the biggest drop over any 3-month period was 20%. From August to November of 2008, it has been 37%.

UPDATE: Actually, if you use the CRB Spot Index, apparently the only one available before 1974, the contrast is even more dramatic. The biggest 3-month drop 1951 though 2007 is 14%. Over the last 3 months it has been almost 27%.

Interestingly, prior to 2008, the biggest drop in the spot index comes at a different time than the biggest drop in the futures index (even though both drops are during the period when both indexes are reported). The biggest drop in the spot index was from July to October 2001 (a time most readers will remember, especially those who were working in Lower Manhattan). The biggest drop in the futures index was from November 1974 to February 1975, where it's harder to find an obvious event to explain the drop. (The fastest part of the drop was in December 1974. The US was going deeper into what was, at the time, the worst recession since the Great Depression. Perhaps someone who is old enough to have been an adult at the time can remember something more specific, but I'm at a loss.)

Also note the corrections above. The data start in 1951, not 1950.

Deflation Can Happen

2008-11-29T10:33:00.004-05:00

I’m not saying it will happen, or even that it’s likely. As a matter of fact, if you offer me less than 6:1 odds, I won’t even consider a bet on deflation, even taking into account its hedge value (since deflation is likely to be associated with bad real outcomes). But what puzzles me is that James Hamilton seems unwilling to take that bet at any odds. This despite the fact that he repeatedly acknowledges the deflation that Japan was still experiencing less than a decade ago.

He makes an argument (which I will address presently) that the Fed can stop deflation, and he seems to draw from it the conclusion that the Fed will stop deflation. It seems to me he could have made essentially the same argument 15 years ago in Japan, and it would have been wrong. I guess he thinks that, since we have learned from Japan’s mistakes, we can be confident that we will avoid making the same mistakes and therefore confident that we will avoid deflation.

I expect that Japanese policymakers thought they were avoiding the mistakes the US made in the 1930s. And to some extent, they surely were. There is far from universal consensus on what exactly those mistakes were in the first place, but perhaps the single biggest mistake the US made was in using monetary policy to defend the dollar. I expect that Japanese policymakers were congratulating themselves for long ago having had the good sense to float their currency so that mistake wouldn’t happen. (In the years leading up to the deflation, they arguably made the mistake of allowing the yen to appreciate too much on its own, but that's not something they should have learned about from the 1930s.) Another commonly ~~alleged~~ cited mistake the US made was in not using monetary policy to offset the effect that the contraction of the banking system had on the aggregate money supply. I just pulled up some statistics on Japanese monetary aggregates, and I see that Japan definitely did not make that mistake either.

A doctrinaire Keynesian will tell you that the biggest mistake the US made in the early 1930s was in not providing an adequate fiscal stimulus. It’s clear in retrospect that Japan did make that mistake in the 1990s (and early 2000s), but at the time I expect they thought they were avoiding it. The fiscal deficits certainly looked huge enough. And in any case, during the 1990s, the preponderance of economic opinion regarding the 1930s was tending to run against the doctrinaire Keynesian explanation. Overall, avoiding the mistakes of the past is not as easy as it might sound, nor is it guaranteed to be effective, and I have less than complete confidence that US policymakers today will succeed either in doing so or in doing so effectively. Even if the Fed can stop deflation, there’s no guarantee that it will.

But can the Fed, by itself, really stop deflation? It’s a difficult question, because it depends on what policy actions the Fed is capable of taking. There are, for one thing, institutional constraints – in particular, laws – that limit the Fed’s potential actions. There also has to be some sort of “sanity constraint.” There are things that the Fed theoretically could do, but it’s impossible to imagine that it ever actually would. There are certain actions the Fed could take that would be guaranteed to stop deflation, but before the Fed would even consider such actions, it would push Congress repeatedly for more and more fiscal stimuli and accept the fact that Congress will sometimes be slow to provide those stimuli. Meanwhile, the deflation could be well underway.

Taking Professor Hamilton’s specific examples:

First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities.

Let’s consider this action in two parts. First, the Fed could buy up enough of every issue to push the market yield down to approximately zero. Then it could buy up the remainder of each issue. Would either of these actions stop deflation? The second, almost certainly not, because it just replaces one zero-return asset with another. The first, maybe, but I doubt it. If people expect deflation and have very little tolerance for risk, they will just hold on to most of the money, despite it’s zero nominal return, the same way they held on to the Treasuries. Really, zero is not all that much lower than the yields on Treasury notes today. OK,

Then buy up all the commercial paper anybody cares to issue.

This is where the sanity constraint comes in. On the one hand, the Fed can buy a large but limited amount of commercial paper from reputable issuers. They’re already doing that, and it’s not working, at least it’s not stopping the economic contraction or the talk of deflation.

On the other hand, the Fed can literally “buy up all the commercial paper anybody cares to issue.” That would stop deflation, I agree, but by a very odd mechanism. Anyone could start a thinly capitalized corporation, issue commercial paper, gamble the proceeds, default (unless they win), go bankrupt, and stick the Fed with the losses. It’s roughly equivalent to dropping money from a helicopter, since the money would be out there in the economy and the Fed would no longer have an offsetting asset. In general, such policies that actually create large amounts of new financial wealth, rather than exchanging one form of wealth (i.e. money) for another (i.e. bonds), can stop deflation. But creating financial wealth by deliberately lending to borrowers that are likely to default, this is way too far afield from what the Fed is supposed to do, and it’s not something the Fed ever will do intentionally. But OK:

In fact, you might as well buy up all the equities on the Tokyo Stock Exchange.

There are really two parts to such a policy: first, the Fed would create dollars and use them to buy yen; then the Fed would use those yen to buy equities. First of all, could buying yen stop deflation? Well, yes, if we could take Japanese monetary policy as exogenous: if you devalue your currency enough, it will eventually stop deflation. But more likely Japan would respond by buying dollars, and exchange rate wouldn’t change much.

What about buying equities? In any case it would be more effective to buy US equities instead of Japanese. That would stop deflation if done on a sufficiently large scale. Unlike bonds, stocks have no inherent price limit, so if the Fed were willing to pay a sufficiently high price, it could create enough new financial wealth to stop the deflation. But is the Fed allowed to buy equities? My guess is it’s not, but I may be wrong. And if Fed does buy equities, is that still “monetary policy”? The government taking an equity interest in private sector firms sounds like fiscal policy to me.

And if the Fed can buy direct interests in real goods and services (such as equities, which represent partial ownership of capital goods), why not have them stop the deflation directly by buying consumer goods? Let the Fed put huge amounts of gift certificates on the asset side of its balance sheet. That will do the trick. I’m not sure at what point you start to breach the sanity constraint, but to me gift certificates actually seem like a more reasonable asset for the Fed to hold than junk paper.

Anyhow, I’m sure that, between the Fed, the Treasury, the president, and Congress, they can eventually come up with a way to stop deflation. Whether it’s done by expanding the Fed’s role in previously unimaginable ways or by more traditional fiscal stimuli, it will eventually be done on a scale large enough to be effective. I’m confident of that, but I’m not entirely confident that we will reach that point before experiencing a decade of deflation.

Giving with One Hand and Taking with the Other

2008-11-28T15:02:00.001-05:00

I admit I supported Barrack Obama in both the Democratic primaries and the general election. I still think he’ll make a better president than either John McCain or Hillary Clinton would have. And I think he’s quite an intelligent person, with a reasonable layman’s understanding of economics. But every now and then he says the dumbest-ass things.

I think the phrase “universal coverage” alone should be sufficient to substantiate my point. But the universal coverage thing was a merely semantic piece of nonsense. I doubt it interfered much with people’s ability to judge health policy proposals on their substantive merits. And after all, it had a certain entertainment value, like when the Wizard of Oz says, “Pay no attention to the man behind the screen.” It’s always fun to hear someone deny the obvious.

I’m worried, though, that the president-elect is now having one of his attacks of nonsensicality in a context that has actual policy implications, and policy implications that might be of some importance given the severity of the current economic crisis. Apparently, if I understand the press reports correctly, he is saying that he will finance part of his fiscal stimulus by cutting out wasteful and ineffective government spending.

I’m not going to push on the point that wasteful spending could be more effective than useful spending in preventing deflation, but surely wasteful spending is at least almost as effective as useful spending in stimulating the economy. If you increase useful spending while decreasing wasteful spending by the same amount, what you end up with is very little, if any, economic stimulus. (I must say, though, I’m optimistic that the incoming president will not be able to find and eradicate enough waste to pay for much of his stimulus plan. To the extent that it exists at all outside the fantasies of reformist politicians, wasteful spending is generally there because somebody wants it to be there, and usually the relevant somebodies have quite a bit of influence on Capitol Hill, which is why the spending hasn’t already been cut.)

Here’s one way to see the point. I expect that part of the stimulus plan will consist of increases in government benefits, such as unemployment benefits, and an expedited implementation of the promised middle class tax cut, perhaps with some additional temporary tax relief added in for good measure. Now, when the government sends somebody a check, does it really make any difference whether they call it, on the one hand, a paycheck, or, on the other hand, a tax refund or a benefits payment? The employees involved in wasteful government activities are getting paychecks. Is there any net economic stimulus to be had by taking away their paychecks so that you can send the money to someone else as a tax refund or an unemployment benefit?

If anything, I’d say it’s just the opposite: when someone loses a wasteful government job, their permanent income declines dramatically, and they’re likely to curtail their spending dramatically. When someone receives a larger tax refund or a larger benefits check, they’re not likely to consider it a significant increase in their permanent income (even if the tax cut is ostensibly permanent), and, under the current environment, they will likely find it prudent to save most of the money for a rainy day, especially seeing that the barometric pressure is already low and falling.

I don’t deny that the choice of where to spend stimulus money can be important, or that, in some cases, the effectiveness of a stimulus can be increased by combining the net increase in spending with a shift of spending between different categories, projects, etc. In particular, some types of government spending are likely to produce more and better jobs than are other types. But is there any reason to believe that there is a correlation (in the short run, anyhow) between spending that is wasteful and spending that creates fewer or worse jobs? Is there any reason to believe that useful spending, as such, is the type that will create more and better jobs in the short run? I can’t think of a reason.

Offhand, again, I would guess that it’s the other way around. If the wasteful spending didn’t involve many good jobs, then there wouldn’t be many people with good jobs to protect who would have a strong interest in maintaining that spending, and Congress would have cut it long ago. The useful spending, on the other hand, could be justified on the basis of its usefulness, and, even if there were few good jobs to protect or special interests to satisfy, Congress might have thought it more prudent to keep than to cut.

I have to acknowledge that the one actual example Mr. Obama gives of wasteful spending – subsidies to rich farmers – is one that actually does create fewer jobs than an equal expenditure from the stimulus plan would probably create. But still, the subsidies themselves are certainly a positive stimulus, and it doesn’t make a whole lot of sense to cut them at just the time when a stimulus is needed. You could make an argument that the case for cutting them in the long run is so strong that we should take advantage of any opportunity, even if it’s at the worst possible time. But that argument seems kind of lame to me.

So, Mr. President-elect, once this crisis is over and we have reversed the economic contraction, escaped safely from the threat of deflation, and set ourselves on a healthy and robust macroeconomic trajectory, I will enthusiastically support attempts to cut wasteful government spending. (After all, as everyone knows, the support of anonymous bloggers is critical to the success of any public policy initiative.) Actually, maybe not so enthusiastically, because I have some concern that the project of identifying and eradicating government waste may itself be a waste of the government’s resources. But if that’s your thing, more power to you. Just don’t do it now.

Are Useful Projects Really Better than Useless Ones?

2008-11-26T13:52:00.004-05:00

In my last post I argued

...the general purpose of stimulus packages is to mobilize the economy's unused resources, and, in this particular case, to...prevent prices from plummeting. Does the presence of pork in a package...in any way hinder the pursuit of such purposes? As far as the deflation issue is concerned, useless projects are precisely the place we should be putting our power. Useful projects will augment aggregate supply and thus push against the attempt to arrest falling prices. Instead of one bridge to Nowhere, let's have two! Just so the builders of those bridges can use up labor and make it harder for others to hire, thus halting the hemorrhage of wages and helping stabilize the price level.

An anonymous commenter replies:

I think we need useful projects. Can you explain how this works with the aggregate supply thing you mention? I don't understand why we would favor useless projects over useful ones.

All things considered, I will also tend to prefer useful projects over useless ones, but there really is a respectable case to be made for deliberately wasting the government’s money (recognizing, of course, that under the current circumstances, the government can create the money out of thin air, so the only real cost is opportunity cost).

The underlying premise is that deflation is very bad and reasonably possible, or, more precisely, that it is bad enough and possible enough to be a greater concern than productivity and, to some extent, a greater concern than employment. (I could be even more precise by talking about integrating across multidimensional probability distributions the convolution of the social welfare function with the aggregate supply function, or something like that. I’m too lazy to figure out how to say it right, and I doubt anyone cares anyhow.)

First, to justify the underlying premise: why is deflation very bad? Deflation means that money increases its purchasing power over time, which is to say, it becomes more valuable over time. Under those circumstances, people will prefer to hold their wealth in the form of money rather than investing their wealth in real capital such as computers, buildings, and research. The decreased demand for real capital goods will cause prices to fall further. Even prices for other types of goods and services will fall: workers who make capital goods (computers, buildings, &c) will be laid off, and employers in other industries will be able to hire them for lower wages, or use them to increase bargaining power over current employees, thus lowering their costs, whereupon competition from other cost-reducing firms will force them to lower prices. When prices fall, there is (by definition) more deflation, and we get a vicious circle between declining real investment and declining prices. Also, with deflation and widespread layoffs, people will choose to save as much as possible to prepare for the possibility of job loss, and consumption will decline, and with lower demand, prices will fall, and thus there is another vicious circle. Really, deflation is very bad. (As to whether deflation is reasonably possible, I think TIPS yields tell the story.)

So let’s suppose the government has a choice between two projects, a Bridge to Nowhere, which is completely useless, and a Bridge to Somewhere, which is useful. What happens if they choose to build the Bridge to Somewhere? It becomes cheaper to ship goods to Somewhere, so the people of Somewhere can get those goods for lower prices, and goods in the stores of Somewhere have lower price tags. We can quibble about the definition of deflation, but certainly we should expect the Bridge to Somewhere to result in falling prices, at least in Somewhere. If the government undertakes similarly useful projects of various types in various places, the result will be broadly declining prices. That is deflation. And deflation is very bad. Spend money on useless projects such as the Bridge to Nowhere, and we avoid that deflationary impact.

One way to think about this is in terms of the monetarist quantity equation, which I learned as


MV = PQ

where

M=quantity of money
V=velocity of money
P=general price level
Q=quantity of goods and services produced

If the product of M and V is constant, then if Q goes up, P must go down. So if the government expects that product to be constant, and it wants to avoid declines in P, it should choose projects that don’t increase Q, which is to say, useless projects.

You might ask why anyone would expect the product of M and V to be constant. If Q is going up too quickly, wouldn’t the government just increase M and thus avoid declines in P? That is usually the right answer, since V doesn’t usually depend heavily on M. The late 1990s are an example. Q was rising quickly, and V was reasonably stable, so the Fed wisely chose to increase M quickly to avoid declines in P.

But things are different today, because we are in a liquidity trap. People (and, more to the point, institutions) are so eager to keep their assets safe and available that they will save any money the government can create. If all the new money is saved, it goes nowhere: it has zero velocity, so the average velocity of money goes down. Thus, with increases in the money supply, the (average) velocity of money declines in such a way as to exactly offset those increases, and the product MV remains constant. The only way to get P up is to decrease Q.

Well, OK, you could also try to increase V, which is the point of a stimulus program: the newly created money goes to the government, which spends it, so it has some positive velocity, and the increase in M is no longer entirely offset by the decrease in V. But while increasing M is easy, increasing V can be difficult, since in this case it requires an act of Congress, which may be hesitant due to concerns about government debt and the like. So it would help to try decreasing Q, or at least limiting its increase, at the same time as trying to increase V.

As I said, all things considered, I would still favor useful projects, but I don’t think this argument for useless ones is just academic sophistry. After Franklin Roosevelt was elected during the Depression, he didn’t deliberately spend government money on useless projects, but he did something with a similar effect: he spent money on useful projects, but he offset the overall macroeconomic effect of their usefulness by creating government-sponsored cartels to keep prices up. The majority of economists have now decided that cartel-sponsorship programs such as the National Recovery Act were counterproductive, but there is still a significant minority who disagree (and I should say, I’m rather sympathetic to their point of view). I have to ask that minority (and I’m serious; this is not an attempt at reductio ad absurdum): rather than going to the trouble of setting up the cartel-sponsorship apparatus, wouldn’t it be easier, and just as effective, to spend the government’s money on useless projects instead of useful ones?

Pork is Good for You

2008-11-25T10:18:00.005-05:00

(My apologies to those with religious dietary restrictions...and to those who hate the letter P)

Greg Mankiw's hypothetical alliterative stimulus critic worries that the stimulus package will be "pointless, political, and pork-filled." Perhaps. But it's hard for this person to perceive how a proposal that is political and pork-filled would be probably, or even possibly, pointless. To prefigure my point, perforce, the politicians and pork-purveyors must have had a point in preparing to pass the purported pork-proliferating package. Otherwise, why pother...um, I mean, why bother?

All alliteration aside (but apparently now actively assonant), the general purpose of stimulus packages is to mobilize the economy's unused resources, and, in this particular case, to (sorry, I can't help it) prevent prices from plummeting. Does the presence of pork in a package (really, I'm sorry, but I give up) in any way hinder the pursuit of such purposes? As far as the deflation issue is concerned, useless projects are precisely the place we should be putting our power. Useful projects will augment aggregate supply and thus push against the attempt to arrest falling prices. Instead of one bridge to Nowhere, let's have two! Just so the builders of those bridges can use up labor and make it harder for others to hire, thus halting the hemorrhage of wages and helping stabilize the price level.

My other point is that, in any case, pork projects actually will be useful to someone. Somebody wants to drive to Nowhere, and that's why they want to have the bridge built. It might be pointless to divert resources toward such projects when the economy is already using most of its resources, but today (and in a few months, when there will be even more slack resources), the pointless thing would be to let those resources be wasted. Pork may not be the best use of those resources, but it's better than nothing.

And there is also the secondary effect, the Keynesian multiplier. The people hired to build bridges to Nowhere will spend some of their new wages on things that they want. When those things are produced, the resources involved are clearly being put to good use, because they create something that somebody wants and is willing to pay for.

So, to push the parlance of this passage past the point that people can put up with prior to puking, as the penultimate paragraph presages, there is plenty of point to pork-barrel politics when it comes to the passage of programs to prop up our pained pecuniary polity and positively impact its per capita product and probable performance.

Why Even Bad Bailouts are a Good Deal

2008-11-25T10:00:00.000-05:00

Why? Because the government gets to pay with monopoly money and get paid back with real money.

Right now, with the T-bill rate at approximately zero, the Fed can effectively create an unlimited amount of money to finance the government. No matter how many T-bills the Fed buys, the rate won’t go much lower than it already is, so such purchases, even on a very large scale, won’t have much economic effect (and if they do have an economic effect, so much the better). So anything the government pays today, it can pay with free money, money that it created out of nowhere (and for some reason, people are all too willing to accept it as payment for all sorts of things).

Eventually (one should at least hope) this crisis will be over and the economy will recover, putting upward pressure on prices, causing the Fed to tighten, raising the government’s borrowing costs. Isn’t it nice that a bunch of folks are going to be owing the government a lot of money at just that time? And many of them will finally be able to pay, which means there is so much less that the government will have to borrow now that it can no longer print money with abandon.

As long as the crisis continues, the deflationary pressure will continue, T-bill rates will stay near zero, aggressively expansionary monetary policy will be warranted, and the government can continue to make payments with monopoly money. If Citicorp’s assets go sour, chances are this situation will be continuing, and the government can pay out those guarantees with monopoly money. And if the crisis continues for 5 years or 10 years, that’s so much longer that the government gets to print worthless pieces of paper (in the usual trope, though most money isn’t literally paper) and make various assetholders happy by allowing them to retrieve these worthless pieces of paper. And if the government takes some losses in the mean time, who cares? Yes, it will have to print up more worthless pieces of paper. So what?

When the recovery finally comes, everyone to whom the government has lent these worthless pieces of paper (all the ones that are still solvent, anyhow), and whose loans it has rolled over and over as the crisis continued, will have to pay up. It’s like a huge, temporary tax increase, just when it’s needed, only without having to actually raise taxes.

Gurantee the Liabilities

2008-11-24T23:03:00.002-05:00

Here's my Monday evening quarterbacking. They should have guaranteed Citigroup's liabilities (in other words, extending deposit protection to other types of creditors and to large depositors) rather than its assets. (Perhaps nobody had the authority, but Congress should give them that authority now in case the same thing happens again.) The liabilities are effectively guaranteed anyhow, because officials know better than to let Citi ever actually default. But as long as the liabilities are not explicitly guaranteed, the company essentially has the financial system as a hostage. They won't threaten to kill the hostage intentionally, but when they bargain with the government, they can threaten to take the risk (i.e. to refuse a bailout on the government's terms, thus putting the hostage in peril). This gives them a bargaining chip. If their liabilities were explicitly guaranteed, they would lose that bargaining chip, because the government guarantees would insulate the rest of the financial system. Then the government could bargain thusly: "Accept our bailout that wipes out 98% of your equity, or else we'll force you to write down your assets and recognize your off-balance-sheet liabilities until you have no equity left, and then we'll take over, and believe me, that won't be pleasant for the current management."

Memo to Tim Geithner: Retire the TIPS

2008-11-23T19:57:00.003-05:00

Before the Treasury decided to start issuing TIPS, I was a strong advocate for inflation-adjusted bonds. At the time, I felt that people were overly concerned with inflation. (That was the mid-90’s, and I think subsequent experience bore out that opinion.) I thought that the government should issue indexed bonds to, as it were, take inflation off the table – to give people worried about inflation the opportunity to hedge, and to reassure markets that inflation was not the government’s intention. This, I thought, would give macro policymakers the opportunity to experiment more, having effectively given assurances that, if their policies were lead to a bout of excessive inflation, they had every intention of nipping that in the bud.

But times have changed. A few economists may still be worried about the possibility of inflation at a long horizon, but the consensus of the bond market seems to be more concerned about deflation, particularly at a short-to-intermediate horizon. In fact, some TIPS appear to be trading at yields higher than the corresponding nominal Treasuries. That doesn’t make any sense to me, because, as I understand it, TIPS principal cannot be adjusted downward in nominal terms, which, if my logic is correct, means that, when you buy a TIPS at a yield higher than the corresponding nominal, you are guaranteed a higher return when you hold it to maturity.

I don’t feel like working out the algebra right now, but I’m pretty sure that kind of thing isn’t supposed to happen in a market with rational agents -- unless of course the agents don't realize that one another are rational. (I can see how it might happen in a CAPM-type model in which the agents don’t care about higher moments, since nominal Treasury returns might be negatively correlated with other asset returns; but this is a case where the higher moments obviously matter: whatever the means and variances might be, if portfolio A outperforms portfolio B under every possible outcome, then portfolio A is obviously better.) It’s certainly true that there is a liquidity premium in TIPS yields. But it’s hard for me to believe that the bid-ask spread on TIPS is large enough, or expected to become large enough, to justify the kind of yield spreads we’re seeing. Perhaps there is some other technical reason that I don’t understand.

Anyhow, rational or not, TIPS are obviously cheap today. Moreover, this is not a time when the government should want to reassure people of its intention to avoid excessive inflation. There is an overwhelming demand for safe assets, and the way to get people to invest in other assets is to take away the opportunity for safety. The US government should be happy to do anything that will make people worry that real Treasury returns are vulnerable to inflation. Not that I’m advocating intentionally high inflation: I’m just saying don’t make any promises.

Moreover, the government, which can issue its own Treasury bills whenever it needs access to cash, doesn’t have to worry about liquidity. The government should be happy to provide more liquidity to the market and to earn the liquidity premium in return. And if market agents are being irrational (as they apparently are), it’s in the public interest for the government to set them straight and to make a profit in the process, while also reducing its long term risks. So it is both good macro policy and good financial policy for the government to be on the buy side in the TIPS market.

I therefore recommend that the Treasury stop auctioning TIPS until further notice and begin bidding for TIPS in the open market with the intention of retiring them and issuing nominal securities in their place. When times change again, when inflation becomes a big concern in the market, when inflation protection is once again something that people are willing to pay for, then it may be a good time to start issuing TIPS again. Sell high, when you have the opportunity, but right now it’s time to buy low.

UPDATE: Foster_Boondoggle points out in a comment that my argument about irrational valuation doesn't apply to outstanding TIPS for which the principal has already been substantially adjusted for past inflation, since subsequent deflation will still reduce the value of the TIPS. So I was wrong to suggest that the market was necessarily irrational and that the government would be taking a sure bet by retiring TIPS.

However, I do think the government would be taking a pretty good bet, especially since deflation would give the government the ability to do virtually unlimited seignorage (thus more than compensating taxpayers for losing the inflation bet), whereas if there is greater-than-expected inflation, the government's borrowing costs will likely go up. In other words, if the TIPS-to-nominals spread is actuarially fair, then the government is getting a costless hedge by retiring TIPS. Also, my argument about the effects on expectations becomes stronger: by retiring TIPS, the government is explicitly betting against deflation, which should increase the market's confidence that it will try harder to avoid deflation.

Deflation?

2008-11-20T18:17:00.002-05:00

The bad news is that the headaches and fatigue you’ve been experiencing aren’t just stress. According to our tests, you have a serious illness, and if it’s not treated soon, you could be dead within a year or two.

The good news is that the treatment is 100% covered by your health insurance, and with a good, aggressive treatment plan, you should be virtually symptom-free within a few months.

Some patients do experience side effects, but those are generally quite mild except at extremely high doses. In rare cases, where patients had doses far above the therapeutic range, some of the side effects have persisted after the treatment was finished, but those side effects can also be treated, so that’s not something you should be worrying about.

I have to warn you, doctors have had a tendency to be too conservative in treating this illness, and some patients have remained very sick for years – not because they couldn’t be cured but because doctors were uncertain about the right dosage. Given the balance of risks, it’s always better to prescribe too much than too little, and the therapeutic range is actually fairly wide, so with appropriate treatment, you should never have to experience the more painful symptoms that people in advanced stages of the disease go through.

There isn’t really much good news or bad news right now with respect to the possibility of deflation. Yes, there was a record drop in consumer prices in October, but that was mostly due to rapidly falling energy prices, which are unlikely to fall much further (although they have continued to fall in November, so we should expect one more large drop in the CPI next month). The core CPI also fell, but by only one tenth of a percentage point, which should not be alarming. (The last time the core CPI fell was in 1982, but such drops were not uncommon during the early 1960s – a time of some economic weakness but hardly a depression.) So the tests are inconclusive at worst, but it would be reasonable to begin some prophylactic treatment.

If there does turn out to be deflation, will that necessarily be a bad thing? It will be quite bad if it’s allowed to persist for years, but if it’s handled appropriately, it has a good side too. Basically deflation means that the Fed can create huge amounts of money without having much of any ill effect. (What would you be worried about? Inflation?) Those huge amounts of money can be used to finance huge federal deficits for a while without having to borrow additional funds from the public. So even a shockingly large fiscal stimulus could be more or less free – paid for by seignorage in an economy where people are only too eager to accept intrinsically worthless fiat money as payment for real goods and services. (That’s essentially the definition of deflation. Money has no intrinsic value, but in a deflation, producers offer greater and greater quantities of goods and services in exchange for a given amount of money.)

So if the headaches and fatigue that the US economy is beginning to experience turn out to be symptoms of the serious illness known as deflation, the treatment will be 100% covered. And with a good, aggressive treatment plan, we should be virtually symptom free within a few months. Not that that’s likely to happen, but I’m more afraid of the timid doctors in the US Congress than I am of deflation per se.

Deficit Hawks are Like Protectionists

2008-11-12T17:47:00.002-05:00

Everybody knows that, in the aggregate, trade increases welfare. We can quibble about how to aggregate welfare across individuals, but at least in a Kaldor-Hicks sense, trade increases welfare. In that aggregate welfare sense, trade is a free lunch, and that lunch is wasted if nobody eats it. But protectionists argue that the redistributive effects of trade can often be bad enough to outweigh the aggregate advantage. Trade can hurt certain parties that one may wish not to hurt. The overall pie is larger, but someone’s share may be smaller.

When an economy has slack resources, as the US economy – as well as the world economy – clearly does now and likely will even more in the immediate future, there is no aggregate welfare cost to using up those resources, so any benefit society receives is, in the aggregate, free. In an aggregate welfare sense, slack resources are a free lunch, and that lunch is wasted if nobody eats it. Deficit hawks talk about the cost to taxpayers and the cost to future generations and all that. But let it be noted that fiscal stimuli during times of slack resource use make the overall pie larger, and any objections must rest on the premise that the new division of the pie leaves some particular party with a smaller slice despite the larger pie. It’s pretty much analogous to the argument for protectionism.

You can argue about whether resources are truly slack. There is a labor/leisure tradeoff, you might say, so there is always a cost to employing those supposedly slack resources. I warn you not to make that argument, because I will counterattack by taking a more extreme position than I took originally: not only are the resources slack; they are more than slack. In an aggregate welfare sense, you actually get a bonus for using up those resources, even if they don’t produce anything. It seems obvious to me that the emotional pain involved in unemployment typically outweighs the value of the additional leisure. (I know you’ll give the counterexample of your cousin who had always wanted to learn to play the guitar and he finally got the chance when he lost his job: but your cousin is not typical.) Add in the search costs, and it’s a slam-dunk. At this point I might be willing to compromise and say that the resources are just plain slack, not “hyperslack,” if you agree to abandon once and for all the labor/leisure argument.

Now I also hear echoes in my head saying, “There is a cost to using those resources, because, even if they are in some sense slack, the additional demand will shift the Phillips curve and raise the expected inflation rate.” Dude, that’s not a cost! Have you noticed that the nominal 10-year Treasury yield is trading less than 100 basis points above the comparable TIPS? How you noticed that the price of oil has fallen by more than 50% over the space of a few months, and that other commodity prices have fallen dramatically too? Have you studied what happened in the US in the early 1930s, and in Japan in the late 1990s? Gimme that expected inflation, Baby, and give it to me hard!

OK, sorry for the vulgarity, but back to the original point: just like the protectionists, the deficit hawks must be concerned about the redistributive effects of deficits, since the aggregate effect is to increase welfare. But while the protectionists actually have a pretty good argument (at least at the national level, in developed countries) as to why the redistributive effects are bad and might be expected to outweigh the aggregate effects in terms of importance, the deficit hawks’ arguments seem pretty lame to me.

The main issue would seem to be redistribution from future generations to the current generation. Here’s a point I made a couple of years ago, but I’ll repeat it: in the history of capitalism, there has been a consistent long-term trend of increasing welfare, by pretty much any reasonable measurement. You can complain about some of the things that have gotten worse, but the fact is, the19th century really sucked for most people, and the 18th century sucked even worse. And compared to the 1990s, the 1920s sucked, too. Unless we expect the trend to suddenly reverse itself, the likelihood is that future generations will be, in the relevant sense, richer than the current generation. So the deficit is a transfer from relatively rich future generations to the relatively poor current generation. I would hope that those future generations could spare a few extra pennies for such miserable folk as we. Especially since it is our blood, sweat, and tears that will have made them so rich. It is through no merit or toil of their own that they will come of age using microprocessors that run 1000 times faster than the ones we use today.

There are other arguments, but they’re even lamer. There is the idea that we will be paying interest to the Chinese for decades, as if that constituted a transfer of wealth from the US to China. It’s actually just the opposite. We are paying chicken shit interest to the Chinese, because they are so eager to keep their currency weak that they willingly overpay for US assets. Meanwhile, any reasonable capital investment by the US government will produce higher returns. Maybe we use the money for consumption rather than capital investment, but that the just brings us back to the “future generations” argument.

The Chinese Fiscal Stimulus, correction

2008-11-11T19:24:00.002-05:00

Damn, this gets so complicated when you try to do it rigorously. In my earlier post, my mind had scrambled together 3 or 4 different models, thrown in some extra stuff to try to make the result realistic, and ended up with a high-cholesterol omelet. Now that I have separated the yolk from the white and the white from the cheese, and taken out the bacon that was supposed to make it realistic, the result is much tighter theoretically but difficult to explain in a single blog post. The bottom line is that, according to standard Keynesian-style models with (usually assumed but obviously not realistic in China’s case) perfect capital mobility and perfect asset substitutability, the Chinese stimulus has an unambiguously positive (well, non-negative, anyhow) effect on non-dollar countries and an ambiguous effect on dollar countries (particularly the US).

The two critical elements of the reasoning are

that the stimulus causes Chinese to import more (possibly indirectly) from the US (likely, since China is not self-sufficient, and some of the additional things the Chinese will want to buy will be things that are made in the US – certain kinds of business services, for example).
that the stimulus causes the value of the dollar to rise against floating currencies such as the euro (usually considered likely for the reason I gave in my previous post – that the financing of the stimulus will put pressure on credit markets, thus raising dollar interest rates and making dollars more attractive relative to the floating currencies)

Contrary to what I said in my earlier post, the first of these effects should dominate the direct effect of rising interest rates rather than the other way around, and if it weren’t for the floating currencies, the stimulus would be at worst neutral, and more likely positive, for the US. However, the indirect effect of rising interest rates – namely the strengthening of the dollar – is negative for the US, since it makes US goods less attractive relative to goods from floating-rate countries. The direction of the net effect on the US is ambiguous. One should note also, though, that the stimulus will have an unambiguously positive (well, again, non-negative) impact on the floating rate countries, because (among other things) it will weaken their currencies and make their goods more attractive.

I started out writing a post that tried to explain all this in more rigorous detail, but it got hopelessly long and complicated. I might put the explanation in the next post, but I’m trying to keep this one reasonably user-friendly

When you introduce imperfect capital mobility and imperfect asset substitutability, the story becomes even more complicated, and I haven’t even thought through the implications. Imperfect capital mobility and imperfect asset substitutability essentially represent the idea that China’s monetary policy doesn’t have to depend on its exchange rate policy. In other words, China can affect the exchange rate by, in effect, swapping huge quantities of Chinese bonds for huge quantities of US bonds. Institutionally speaking, China issues renminbi bonds, uses the proceeds to buy dollars, and invests the dollars in dollar bonds (really in Treasury notes, mostly). Ordinarily the effect of such intervention would be offset by the actions of private investors, but China can do it on such a massive scale that it overwhelms the actions of private investors. Moreover, China can restrict the actions of investors.

To the extent that imperfect asset substitutability is important here, I got things completely backwards (sort of) when I said

...given China’s de facto currency peg, [the stimulus] will have to be financed by reducing purchases of foreign assets (particularly US government securities).

Wrong! Actually, if China operates fiscal policy, monetary policy, and exchange rate policy independently from one another, it will have to buy more US government securities, not less. The fiscal stimulus will raise Chinese interest rates (and also probably make investment activities in China more profitable in general), thus making renminbi more attractive to investors. The Chinese authorities will have to offset the incipient increase in the value of renminbi by absorbing all the new dollars which investors want to exchange for renmibni that they can use for investment in China. Then the authorities will invest these dollars largely in US Treasury securities.

But here’s where the “sort of” part comes in: the increased demand for US Treasury securities, while indeed it doesn’t increase overall stress on US asset markets, doesn’t actually reduce such stress either. The whole point of buying the dollars to be invested in US Treasury securities was to offset what private investors were doing: taking dollars out of US assets and putting them in Chinese assets. All things considered, the effect China’s attempt to maintain its exchange rate will indeed be bad, because it will shift demand out of US private assets into US public assets, when the big problem in the US now is that everybody wants Treasury bills and nobody wants anything else. We want people to keep their risk capital in the US, not move it to China. So, the reasons are much more complicated than I thought, but we can still expect that the Chinese stimulus might have a detrimental effect in the US.

GM is not Lehman

2008-11-10T11:42:00.004-05:00

I’m generally in favor of bailing out the US auto industry, mostly because such a bailout would be a relatively inexpensive form of fiscal stimulus. Compare the cost of bailing out the auto industry to the cost of trying to replace the lost jobs by means of government hiring. (There will be multiplier effects on both sides of the equation, which should roughly balance out.) Bailing out the auto makers, by just lending to them at below-market interest rates, is clearly cheaper. In fact, the interest rates should still represent a positive, or at least neutral, spread to Treasury rates, so there need not be any cost at all to the bailout unless the bailees eventually do default.

However, comparisons between GM and Lehman Bros. are overblown. The lost jobs at GM could be replaced by means of a fiscal stimulus, albeit an expensive one; the financial impact of the Lehman bankruptcy cannot be undone, though the government is doing its best to mitigate that impact.

An industrial company is simply not the same as a financial company. Yes, the auto companies do have creditors, and those creditors will lose out if the auto companies go bankrupt, and this may have significant adverse indirect effects. And yes, such bankruptcies will somewhat reduce confidence in US industrial companies in general and make it a bit harder (though probably not a lot harder) for them to obtain financing.

But a financial company doesn’t just have creditors, it’s in the business of having creditors. The indirect impact of a major failure – by forcing creditors, and creditors of creditors, and so on, to deleverage themselves – is huge. And a loss of confidence in financial companies doesn’t just make it harder for them to find financing; it instigates a chain reaction of additional deleveraging on a grand scale. And as we have seen, this can make it impossible for many companies (and households) to find financing at all, and such tightening of credit can result in many more job losses than the collapse of a few large industrial companies.

So, yes, I do support an auto industry bailout. But let’s not allow the auto companies to bamboozle us by claiming that their failure would be as disastrous as the Lehman failure. The public should not consider itself to be in a terribly bad negotiating position with respect to the auto industry. Bail them out, but bail them out on our terms, not theirs.

The Chinese Fiscal Stimulus

2008-11-10T11:07:00.002-05:00

[EDIT: OK, I take it all back. Well, not all of it, but some of it. With the benefit of some perspicacious comments, 50 minutes of jogging, and 200 mg of modafinil, I see that I was mixing up several different models in my mind (an inherent hazard when you try to use two-country models to analyze a world where some exchange rates are fixed and others float). In standard Keynesian-style models, the Chinese stimulus is unambiguously good for non-dollar countries, and the effect on the US is ambiguous. I don't have time to explain now or to do the appropriate overstrikes, but I will get to it later and probably add a new post on the subject.]

There’s no question in my mind that the Chinese fiscal stimulus is a good idea – from China’s own point of view, as well as from the point of view of general balance and long-term stability in the world. But I wouldn’t jump to the conclusion that the policy will be good for the rest of the world (or particularly the US) in the short run.

The fiscal stimulus has to be financed, and given China’s de facto currency peg, it will have to be financed by reducing purchases of foreign assets (particularly US government securities). Reduced demand from China will put downward pressure on asset prices in general at a time when falling asset prices (though not specifically US government securities, of course) are already a problem. It will also complicate any US fiscal stimulus by making it more difficult to finance. Moreover, the portion of US deficits that China no longer finances will instead have to be financed elsewhere, and the higher interest rates necessary to attract such financing will tend strengthen the dollar, making US goods and services less attractive. All three of these effects would tend to exacerbate economic weakness in the US.

On the other hand, the fiscal stimulus will also mean increased demand for imports by the Chinese. It’s not clear which effect will predominate. In textbook theoretical Keynesian-style open economy macromodels, the former effects are more likely to predominate, which would mean the stimulus is bad for the US economy. In the real world, it’s not clear that this would be the case, but it’s also not clear that it wouldn’t.

To Hell with the Long Run

2008-11-07T11:21:00.001-05:00

For Christ's sake stop worrying about the long run and whether long run US fiscal policies will be sustainable. We should be trying as hard as possible to undermine confidence in the creditworthiness of the US government, and especially in the soundness of the US currency. We should be doing everything we can to discourage investors from holding their assets in US Treasury securities. We should be following a policy explicitly designed to bankrupt the US Treasury. Some time later (possibly much later) it will be necessary to change this policy, but let's try not to give away the secret that we intend to change it.
Sent via BlackBerry from T-Mobile

Ireland

2008-11-07T11:09:00.000-05:00

It pisses me off that that the EU is taking acton against Ireland for violating the deficit rules. As we face the prospect of a possible worldwide depression, we should be encouraging deficits as large as possible. I think the US should retaliate by pursuing an explicit weak dollar policy, until we break the EU and force them to run large deficits just to avoid becoming the world's economic wasteland.

Sent via BlackBerry from T-Mobile

Broken Links

2008-10-26T21:33:00.002-04:00

I'm starting to notice a lot of broken links on the Internet. I wonder if this is part of the impact of the financial crisis. Maintaining archives on the Web involves some cost for server space, bandwidth, and maintenance costs. When financing was easy and business was good, this cost may have seemed insignificant, and certainly cutting it wasn't a high priority. With business falling off and financing very difficult, every little cash drain has to be closed, so it becomes hard to justify maintaining old Web pages for the benefit of the public. That's my theory, anyhow.

$700 Billion? So What?

2008-10-12T18:32:00.002-04:00

Guaranteeing an asset is equivalent to buying the asset while giving the seller an option to repurchase at the same price. Conversely, buying an asset is equivalent to guaranteeing the asset while retaining an option to purchase at the guarantee price. (The proof is left as an exercise for the reader.)

When Secretary Paulson first proposed the TARP, it was a plan to buy $700 billion worth of assets from banks. Some valid criticisms were made – for example, that the program would do nothing to help recapitalize banks unless the Treasury deliberately overpaid for the assets. But the criticism that seemed to resonate most with the general public was that taxpayers would be “spending” $700 billion (a huge amount even compared to the already historically large budget deficit) to “bail out” the banks.

Suppose instead that Secretary Paulson had proposed guaranteeing $700 billion dollars worth of bank assets – at some appraised value – in exchange for call options on those assets. That’s equivalent to what he actually proposed, but it might have been met with considerably less hostility.

The FDIC already guarantees several trillion dollars worth of deposits (depositors’ assets), at face value, in exchange for a small insurance premium. Guaranteeing a mere $700 billion worth of assets, at a more realistic appraised value that takes into account the probability of default (analogous to the probability of bank failure in the case of deposits), in exchange for a rather valuable call option that will pay off handsomely if the default rate is less than expected (an option which could presumably be sold on the open market, though it may be more valuable to the government, with its large capacity to absorb risks, than to private owners)? That hardly seems like a big deal, and it doesn’t seem to involve any “expense” of taxpayer money – at least not in the short run.

There is, of course, a risk to the taxpayers, just as there already was for the FDIC. The theoretical worst case scenario for the TARP – a loss of $700 billion – is not nearly as bad as the theoretical worst case scenario for the FDIC – an obligatory public bailout costing several trillion dollars.

One may, of course, have valid criticisms for this “equivalent TARP” (“Troubled Assets Guarantee Sytem” maybe – “TAGS”) – the same as the valid criticisms of the actual TARP. Again, the TAGS does nothing to recapitalize banks unless the appraisals are deliberately inflated.

But if the problem – as Secretary Paulson originally seemed to maintain – was just liquidity, then the TAGS would solve it. Assets guaranteed directly by the Treasury are almost as good collateral as direct liabilities of the Treasury, so banks – even suspect banks – would be able to borrow against the guaranteed assets at reasonable interest rates whenever they needed money. They might run out of collateral, but in that case, the bank must have been undercapitalized in the first place.

There are a lot of details to be worked out. For example, what would the TAGS guarantee? Resale value? Reovery value? And how much time has to pass before the guarantee applies? And if an asset is sold, does the call option attach to the asset, or is the original bank on the hook for the option? And so on and so forth. The whole exercise is academic, since Congress has now passed a different version of the TARP. I just wanted to make the point that the TARP was not (and is not) as big a deal as the $700 billion figure makes it sound.

Not Time to Affix Blame

2008-09-29T19:46:00.000-04:00

So let me get this straight. The reason the stock market crashed today is that the Republicans in the House were so immature that a little grudge about something mean that Nancy Pelosi said was more important to them than saving our financial system. Shame on you, Speaker Pelosi!

The US Treasury Needs a Better Marketing Department

2008-09-29T11:44:00.002-04:00

Whether or not Secretary Paulson intended it, the phrase “troubled asset relief program” (TARP), from his original speech describing the program as he envisioned it, lent the standard acronym to his plan to provide liquidity to the financial system by buying illiquid distressed assets. Not a good name for the program, if you want to sell it to the American people. Relief? The banks will be on relief? After getting us into this mess? (The banks are hardly the only culprit, but in the public mind they seem to be the main one.) No way.

If it’s handled well, the program ought to make a profit. And in its current form, even if it doesn’t make a profit, the banking industry is supposed to pay for it after the fact. But even in its original form as proposed by Secretary Paulson, it should (again, if handled well) have produced a profit (although there was, of course, considerable risk of loss). Sell it as a plan to provide “relief” to banks? Why? Granted, that is its primary purpose, but it sure doesn’t sound good if you say it like that.

How about one of these alternative names?

Distressed Assets Marketability Effort
Public High-yield Asset Trust
Taxpayer Opportunity Program
Hidden Asset Value Effort
Committee for Liquefaction and Appreciation of Illiquid Mortgage Securities
Fund for Asset Value Extraction
Fund for the Realization of Undervalued General Assets through Leverage
Government Asset Trading Effort
Fund for the Utilization and Trading of Undervalued Real Estate Securities
Hope to Earn the Liquidity Premium on Undervalued Securities
Organization for the Revaluation by the Government of Assets such as Securities and Mortgages.

OK, maybe not that last one. Probably wouldn’t go over very well with the “family values” crowd. Although...it depends on what you mean by “family values.” In order to have a family you need to....hmm....

Anyhow, those were my ideas for the original proposal. But in its current form, it’s a particularly sweet deal for the taxpayers: zero risk, and the potential for substantial profits. It’s as if an insurance company were make its policyholders pay back any losses that the company took on their claims. I must say: that feature rather soothes my concern that the program would overpay for the assets it purchases (although, of course, the good banks are potentially being asked to subsidize the bad ones, but I don’t really have a problem with that). Under the circumstances, I have a better name for the program:

Program to Cheat Banks Out Of Money

Foolish

2008-09-29T08:37:00.002-04:00

From an email I sent, dated 9/12/2008

I just can’t see the Fed and the Treasury sitting idly by while Lehman starts to go into default. The argument for inaction would be that they don’t want to create incentives for risky behavior in the future, and certainly (if it comes to a bailout) they will try to hit the equity as hard as they can. But letting Lehman fail would create even worse incentives, in that people will be afraid to do business with major investment banks. There is some point at which the issue becomes not “Do you trust Institution X” but “Do you trust the system.” (I’m recalling the old anti-freeze slogan, “If you can’t trust Prestone, who can you trust?”) I think Lehman is big enough to be over that line. Most of the casualties of a Lehman failure would be “innocent bystanders” rather than entities that could reasonably have been expected to realize they were taking excessive risks. And at this particular time, with the Fed running out of monetary policy ammunition and commodity prices falling, I think they would be foolish (and they know it) to risk the kind of economic effects that might follow a further loss of confidence in the financial system.

From another email I sent, dated 9/15/2008

Guess I was wrong about that.

I still don't think I was wrong about the "they would be foolish" part, but clearly I was wrong about the "they know it" part.

From the Wall Street Journal, front page, column 1, dated 9/29/2008

The consequences of the government's decision two weeks ago not to step in to prop up Lehman Brothers Holdings but instead let it collapse look more dire than almost anyone imagined.

I guess the bailout bill, as it turned out, was not nearly as bad as I imagined it might be. But I kind of wish somebody other than Henry Paulson were managing the fund.

Incentives for the Dictator

2008-09-24T17:51:00.003-04:00

If Congress insists on passing something like the Paulson plan, it should have the following feature: The Secretary of the Treasury will no longer get a salary. Instead, he will be paid entirely in the form of a performance bonus. If the TARP makes a loss, he gets nothing. If it makes a profit, he gets a percentage of the profit.

Latest Idea to Fix the Banking System

2008-09-24T09:45:00.008-04:00

Offer to buy $700 billion in preferred stock in a single auction (where banks quote dividend yields to bid on funds, and the bids are accepted starting with the highest until all the funds are used up); put a tax (temporary in principle but with no specific time limit) on bank profits; and regulate banks aggressively to make sure they don't make excessively risky loans.

The tax serves a triple function: first, since banks have an incentive (due to the moral hazard of stockholders with limited liability) to bid too low, the tax recoups the additional risk premium that taxpayers ought to receive (essentially an after-the-fact insurance premium); second, the tax encourages banks to participate in the auction and to bid higher, since they are going to be paying part of the price for the funds whether they get any or not; third, by effectively taking part of the payment as equity, it reduces the incentive for banks to take excessive risks.

The preferred stock will tend to give banks an incentive to take risks, since they need to make a high return on their assets before they get to keep any of the return. It's not clear whether encouraging banks to take risks is a good thing or a bad thing. On the one hand, we want to protect the banks' creditors (mostly the FDIC in the case of commercial banks). On the other hand, we want banks to lend, so as to keep the economy going and enable maximum private investment. To the extent that the FDIC -- effectively the taxpayer -- is the primary creditor, this is essentially a type of fiscal stimulus, although you only have to pay for the stimulus if the banks fail. Considering the likely weakness in the economy over the next few months, it is arguably a good idea to encourage banks to take risks.

UPDATE: More details. Banks should be allowed to make multiple bids, so a bank, for example, might be willing to sell $1 million worth of preferred stock with an 8% dividend and then another $1 million worth at a 7% dividend. Then for any bank that has more than one winning bid, the dividend yield would be the average of the bids, weighted by the size of the bids. The minimum bid would be the 30-year Treasury yield. Every bank should be willing to make some bid, since the minimum bid would be a very good deal for any bank. (Imagine selling a CD that yields the 30-year Treasury rate; you don't ever have to pay back the principal; and if you're a year or two late with the interest payments, it's just fine as long as you've got a good reason. If I were a bank, I sure would be interested in selling that CD.)

Another issue. One (perhaps inevitable) flaw in this plan is that it requires good banks (those which don't need additional capital or liquidity and therefore won't submit winning bids) to pay in part (via the tax) for the sins of their prodigal brethren. Of course, just about any kind of bailout is going to reward the bad banks relative to the good ones, unless (as in my earlier plan) the Treasury can force terms on the banks. To the extent that the good banks are "good" because of good lending and investment practices over the past 5 years, it's unfortunate that they get penalized. On the other hand, to the extent that good banks are "good" because they have been hoarding cash during a crisis (and therefore don't need additional cash), we actually should be penalizing the good banks. During good times, we hope that nobody expects to be bailed out, so they won't take risky actions. During a crisis, we hope that everybody expects to be bailed out, so they will be willing to lend. Given that we are more than a year into the crisis, it's arguable that, overall, penalizing the good banks is not such a bad thing.

Avantages of this plan over those being considered in Congress:

It's simple -- much simpler than any of the plans currently being considered.
It's quick. Since the initial disbursement requires only one simple auction of a well-defined instrument, it will get the cash to the banks much more quickly than a plan that would require auctions on many difficult-to-define asset classes.
It's cheap. Taxpayers are likely to make more profit with less risk. Perhaps more important than the interest of the taxpayers is the reputation of the US Treasury and everyone else who borrows in dollars. With so much government borrowing already, every dollar that the Treasury can save is a larger cushion against the point where its (and the dollar's) reputation is in peril and it (along with all other dollar borrowers) has to pay uncomfortably high interest rates.
It's effective. It's more effective than plans currently being considered, because it solves both the liquidity problem and the capital problem (and does so without deliberately overpaying for assets).
It's Constitutional. It does not give dictatorial powers to a single cabinet officer.
It requires less bureaucracy.
There is less potential for favoritism. There won't be billions of dollars worth of business that Secretary Paulson can give to his former employer. (There may be hundreds of millions, though. This would be the biggest business deal in history by an order of magnitude -- and by several orders of magnitude if you exclude the AIG deal. It's not something that the Treasury department has the resources to do on its own.)

UPDATE2: To mitigate the problem with the tax, there should be a time delay before the tax becomes effective. That way, hopefully, you wait until the bad banks become profitable again, so a greater share of the tax is paid by those who are taking advantage of the benefits.

UPDATE3: The preferred stock should be callable, to facilitate the unwinding of the whole mess once banks become profitable again. Note that banks which have reserved conservatively (as GAAP requires) are more likely than not to make substantial profits as some of their assets turn out to be worth more than book value, and as those assets mature they will be taking in substantial amounts of cash with which to retire the preferred stock.

A Simpler Solution

2008-09-23T10:06:00.003-04:00

I just got an email that proposes a simpler solution to the financial crisis. Just use the $700 billion (or more) to buy preferred stock in shaky financial institutions. That solves both the capital problem and the liquidity problem (the latter by deferring indefinitely the need to sell the illiquid assets) and does so in a way that doesn’t obviously cheat taxpayers. And it avoids all the problems associated with having the Treasury buy and own complex illiquid assets. (And of course the Treasury could sell off some preferred stock in one institution and use the proceeds to buy stock in another institution, so just like under the current plan, money can be reused.)

There is still, though, the moral hazard problem for stockholders with limited liability, so banks have an incentive to overcharge for the preferred stock (i.e. the dividend rate will be too low). So actually taxpayers do get cheated a little bit. There should be some provision for declaring a financial institution shaky and then forcing it to issue preferred stock on terms that are not its own choice. I guess there’s still a place for my idea of making aggressive write-downs and then forcing institutions to sell stock at book value.

UPDATE: My next post refines this idea.

I’ve Solved the Banking Crisis

2008-09-22T20:13:00.003-04:00

Now if I can only get Congress to listen :)

Here is the KNZN-II plan

Give the Treasury authority (or does it already have the authority?), on an ad hoc basis, to make commitments to insure the liabilities of individual financial institutions, so as to prevent “runs” by creditors. (Obviously it will seldom be necessary to invoke this authority for commercial banks, since most of their liabilities are already insured.)
Mandate regulators to be aggressive (in a sense that I will make somewhat more precise later) in forcing write-downs of illiquid or troubled assets.
Mandate financial institutions to accept any bid above book value for an illiquid or troubled asset.
Prohibit the Treasury from bidding more for an asset that it has to in order to be certain of having the bid accepted. (In other words, given 3 above, it can only bid slightly above book value for illiquid and troubled assets – unless it is bidding against a competitor, in which case why would it be bidding in the first place?)
Subject to the above, give the Treasury unlimited authority and discretion (but with certain guidelines) to use TARP funds to buy assets held by financial institutions, including the right to arbitrarily choose institutions from which to buy any given category of asset.
Give the Treasury authority to take over lines of credit and purchase all types of loans from financial institutions that are inadequately capitalized or at significant risk of falling below capital requirements.
For financial institutions that are undercapitalized but solvent and cannot present a credibly reliable plan to achieve adequate capitalization, give the Treasury unlimited authority to use TARP money to take equity positions on its own terms and without the consent of stockholders.
For financial institutions whose capital is adequate from a regulatory point of view but judged to be at significant risk of falling below the requirement given the institution’s current balance sheet (after using any cash obtained from the Treasury’s purchases to retire liabilities to the extent that adequate liquidity can still be maintained), or that are not subject to a regulatory capital requirement but are judged to have too little capital, give the Treasury the authority to use TARP money to take equity positions, subject to the requirement that current equity cannot be valued below book value, but otherwise on the Treasury’s terms and without the consent of stockholders.
For insolvent financial institutions, give the Treasury limited authority to take them over and supply necessary capital so as to avoid bankruptcy, if it is judged to be in the overall interest of taxpayers (where “taxpayers” is understood to mean “concrete people who happen to pay taxes” rather than “abstract people who own an interest in the Treasury”).

Details and Explanation

The point of the ad hoc insurance is primarily to calm creditors who are worried that mandated aggressive write-downs will render an institution legally insolvent.
First of all, from what I remember from when I studied accounting, asset valuations are supposed to be conservative, which is equivalent to saying write-downs are supposed to be aggressive, so it seems to me this point is just saying that regulators have to respect GAAP and do their job correctly. But maybe they need to be reminded. In particular they may need to be reminded that it is someone else’s job to prevent the banking system from collapsing due to banks’ having inadequate book capital.

I would include the specific mandate that regulators should apply appropriate risk premia in valuing risky assets. And set up an oversight board to make sure that they do so. And, in cases where there is a question, require them to produce explicit economic/financial analyses to justify the premia they have applied.

My impression is that inadequate write-downs tend, in most banking crises, to be much more frequent than excessive write-downs. The mandate to be aggressive, while it may be implicit in GAAP anyhow, is meant primarily to correct for this apparent bias.
This mandate essentially says that financial institutions have a fiduciary duty to their creditors. If they refuse a bid above book value, they are essentially gambling with creditors’ money, hoping for an increase in value but risking that the asset will become worthless and bring them closer to bankruptcy.

That’s the theoretical justification. Probably a more important practical reason for the mandate is to prevent the institutions from overcharging the Treasury when it buys assets.
The Treasury cannot overpay. In other words, if it is going to give away money, it must do so explicitly.
The primary guideline for Treasury purchases of assets is to “triage” financial institutions. In other words, give priority to the ones that are illiquid but either adequately capitalized or capable of reducing their balance sheets (once the Treasury’s asset purchases are made) so as to meet capital requirements with a reasonable safety margin, or that are currently thinly capitalized but capable of reducing their balance sheets sufficiently to meet capital requirements comfortably once the Treasury's purchases are made.

If an institution is liquid and meets capital requirements, then buying its assets is not necessary (although it could be helpful, since more liquidity is better). If an institution cannot achieve adequate capitalization, then buying its assets may not do any good (although, if it is solvent, there is a chance that it could be saved). If an institution is insolvent, of course, there is no point in buying its assets, because it will still be insolvent. (You can’t triage a patient who is already dead.)

Another guideline is to give priority to institutions whose failure or illiquidity would have adverse systemic effects.
Technically, the authority to purchase loans is implicit in 5, but I have made this a separate point because it has a different purpose. Rather than providing banks with liquidity, the purpose is to avoid the credit crunch that might result from undercapitalized banks’ having to call in loans and reduce lines of credit.
If you can’t save the bank, take it over. If there is still some shareholders’ equity, no resources should be wasted on haggling about how much this equity is worth. Shareholders are at the mercy of the Treasury. In deciding the terms of the takeover, the Treasury needs to balance the obligation to be fair to shareholders against the obligation to protect the interest of taxpayers.
This will perhaps be the most controversial point, and it may be subject to constitutional challenges. (Even if nobody is allowed to sue the Treasury, presumably they can sue the Congress for making the law in the first place if the law is alleged to be unconstitutional. There might, for example, be 5th Amendment issues, although I would certainly argue that book value is “just compensation.”)

But look, if we’re going to restore confidence in the system, we can’t have a bunch of sick financial institutions refusing medical treatment and risking becoming mortally ill and passing on lethal infections.
It should seldom be necessary for the Treasury to take over insolvent commercial banks, since there is already the FDIC, but in some cases it might be judged appropriate, to better serve the health of the financial system, or to make more effective use of resources, or to ease the financial burden on the FDIC so that it would not require explicit additional funding.

In the case of investment banks and other kinds of financial institutions, a Treasury takeover might often be be judged worth the cost to the Treasury in order to spare the financial system the costs associated with bankruptcy, including potential broader loss of confidence.

UPDATE: Point 10. Authorize the Treasury to buy preferred stock in financial institutions for the purpose of making additional capital available to facilitate lending. Not sure about the details yet, but reading over the plan, I realize it doesn't do enough to facilitate lending. "Adequate capital" isn't enough if it means that banks have to struggle to maintain adequate capital and can't afford to make many loans. The overall purpose of the plan should be not just to restore the health of the system but also to enable and encourage (prudent) lending, since that's the main purpose of having a financial system in the first place.

Acronym Time

2008-09-22T15:00:00.002-04:00

I was a little late to pick this up, but the Paulson plan is now "TARP" -- the Troubled Asset Relief Program, a phrase taken from Secretary Paulson's statement on Friday. Apparently, some commentators had already taken to using this acronym soon after the statement came out. I have to say, the word "Relief" sounds a lot like welfare. Not very encouraging for those who held some hope that the only major objective was to increase liquidity.

I criticized Matthew Yglesias last week for objecting to bailouts in general (and even to the Fed's actions to mitigate the effects of non-bailouts) in the absence of programs to help ordinary people. The more I think about the TARP, though, the more I appreciate his point (at least in this particular case, which didn't exist yet when he wrote that post).

Apparently, we're planning to giving welfare payments (in the form of inflated prices for their assets) to bankers. This isn't really even necessary, but the only alternative might be to compel them to sell at fair prices. As I argued this morning, compelling them to sell at fair prices is a perfectly reasonable policy from a capitalist point of view, but I realize it's not likely to get much support from those who like to minimize government interference in markets. (In this case, though, arguably, it would be government interference for the purpose of mitigating the ill effects of other government interference, so perhaps a minarchist shouldn't particularly object.)

If we're giving welfare to bankers, rewarding them for their imprudent behavior -- well, at least reducing the punishment that markets have visited upon them for their imprudent behavior -- shouldn't we also be giving welfare to people who really need it? There is a moral hazard issue for ordinary people, too, but it's no worse than the issue for bankers. Yes, Democrats, let's attach some aid for Main Street to this Wall Street bailout. Either that or do it right -- make it a fair asset swap and liquidity injection instead of a bailout -- by giving Treasury the authority to force banks to sell at prices it deems fair, and by mandating that it use that authority when the taxpayer's interest so requires.

The Banking Crisis

2008-09-22T14:10:00.002-04:00

Some people think the problem is liquidity. Others think the problem is capital. For some reason, both sides seem to insist that their side is entirely right and the other side is entirely wrong. It seems pretty clear to me that liquidity and capital are both significant problems. Why is there such polarization?

Socialism and the Banking System

2008-09-22T08:56:00.006-04:00

In one recent post, I came close to advocating the overthrow of the capitalist system. Well, not exactly. But I did suggest that a policy which, at the time, I described as “socialist,” or at least a credible threat of implementing such a policy, might be necessary in order to solve the financial crisis in a way that is fair to taxpayers. At the time I hadn’t thought through, on a theoretical level, why such a policy might be necessary. In the context of a later post, I filled in the theoretical details, and I have since realized that the “socialist” policy is not inherently socialist at all, and if properly implemented, it can be defended as a normal part of capitalism.

Essentially, the policy, as I now imagine it, involves having the government act as an agent for creditors “before the fact” of a default. It is, of course, quite common for the government to act as an agent for creditors after the fact. When somebody refuses to pay his debt to you, you don’t go over to his house with a shotgun; you take him to court and let the government force him to pay. But creditors have issues before the fact as well. If debtors have limited liability, they have an incentive to take excessive risks with creditors’ money. Sometimes creditors are in a position to prevent debtors from taking those risks, but sometimes they are not – for example, when the creditors are widely distributed and cannot effectively police the debtors. In those cases, it makes sense for the government to take on the policing role.

The specific issue is whether undercapitalized banks have an incentive to hold on to securities and overvalue them on their balance sheets rather than accept an offer to buy them at fair value. (I’m talking about securities that are very hard to value, so here uncertainty acts like a smoke screen. Nobody can say for sure that the securities are overvalued on the balance sheet. Nobody can say for sure whether the offer to buy was at fair value. Even producing a rough estimate of the value is quite difficult. This allows banks to get away with intentionally overestimating the value, since a creditor of the bank would require substantial resources to determine whether the bank is overvaluing the assets or not, and even then the creditor wouldn’t be able to prove it.)

From the bank’s point of view, there is no difference whether its equity goes into the red or just goes to zero. Therefore, if the fair value of the bank’s equity is already near zero, the bank has nothing to lose by taking excessive risks that could result in increasing the fair value of its equity. The particular excessive risk I have in mind is holding on to an illiquid asset rather than selling it at fair value. If the fair value of the asset goes down, the fair value of the bank’s equity will go negative, the bank will eventually fail, and its creditors will lose money, but the bank’s owners will be no worse off, since the fair value of their capital was zero to begin with. If the fair value of the asset goes up, of course, the owners will be better off, but the creditors will be no better off than they were before.

[EDIT: Note that this same moral hazard exists, to a lesser extent, even when the bank has adequate capital. It may still be in the bank's interest to gamble on recovering more of an asset's original value -- which will flow directly to the bottom line without enriching creditors -- rather than selling it at the current fair value. Usually holding on to the asset will be against the interest of creditors, since the bank has adequate capital already and there is no reason for creditors to want to take risks with that capital [EDIT2: except for the normal, presumably much smaller, risk that the bank takes in the course of its ordinary business, which is necessary so that it can earn enough to pay the interest due to creditors].]

Somehow, the creditors should have a way to force the bank to sell its illiquid asset if it gets a fair bid. Moreover, in a reverse auction, such as is proposed as a way to implement the Paulson Plan, the creditors (and the taxpayers) should have a way to force the bank to bid fair value rather than some higher value. Unfortunately, these are very difficult things to do, because, as discussed earlier, the asset is very hard to value. The only practical way to do it is for the government (or some neutral party) to estimate fair value and then force the bank to sell at that price. (Note: If all banks are behaving in the interest of their creditors, then each one will bid fair value, or near it, in a reverse auction, because the primary interest of the creditors is to win the auction But it doesn’t work if only one bank is doing so and knows that the others are not, because that bank will realize that it can win the auction even by bidding above fair value.)

For a commercial bank, the real creditor is usually the FDIC. The FDIC should have the right to force banks to accept fair value for their illiquid assets, and it doesn’t make much difference if the valuation is done by the FDIC or the Treasury or, for that matter, some other party. And it also doesn’t make much difference who enforces the required sale – it could be the FDIC, or it could be the Treasury acting as an agent for the FDIC.

Of course the resulting reappraisals may be quite agonizing. Some banks that were believed to be adequately capitalized will turn out not to be. They will have to either raise capital in the private sector (possibly by allowing themselves to be bought out) or make a deal with the government whereby the government gives them an infusion of capital in exchange for equity participation (which, after all, is essentially what would normally happen if they raised capital in the private sector).

In some cases banks that were believed to be solvent will turn out to be insolvent. They must be either liquidated or taken over (by another private sector entity or by the government). It might be reasonable to use public funds to reduce their liabilities so that some other institution would be willing to take them over. In the case of commercial banks with insured deposits, the public will end up getting the bill anyhow, so why not do it in a way that is less disruptive and allows the bank to continue operations?

So there you have it: the Knzn plan. I think Maynard would approve. It involves coercion, and in some cases takeover, of private entities by the government, but it’s not really socialist, because that coercion is ultimately on behalf of other private entities with legitimate interests that they are unable to defend. As a side effect of defending those private interests, the public gets a fair deal.

UPDATE: In a comment, Johnchx points out that the existing regulatory mechanism can (and, if it's functioning properly, will) force banks to write down assets to fair value. What the existing mechanism can't do, though (as far as I know), is to force a bank that is adequately capitalized, but just barely so, to sell its illiquid assets if it receives a fair offer. In many cases, such banks will have an incentive to reject offers at book value, when the asset is fairly valued on the books. (See my edit above.)

UPDATE2: In any case, that regulatory mechanism only works for commercial banks. Investment banks are possibly a bigger problem (largely because there is no insurance to prevent "runs").

UPDATE3: In my plan, paradoxically, the creditors, whose interests are being defended in each specific case, end up with a worse deal (at least if the Treasury promises to buy at the reverse auction price). The moral hazard of the bankers essentially allows the creditors to behave like a cartel and extract monopoly profits -- in the form of greater security due to having larger capital cushions -- from the Treasury. But we do have antitrust laws and such to prevent anti-competitive behavior, so it makes sense to enforce fair competition among banks selling securities to the Treasury. It's still not socialism.

The Paulson Plan: Summary of My Recent Posts

2008-09-21T21:06:00.002-04:00

Providing liquidity is what the government should be doing. Recapitalizing banks (without receiving equity participation) is what the government should not be doing. If the government does the former and not the latter, then, although taxpayers are taking a large risk, they should expect, if things go well, to make a very large profit. Unfortunately, after careful consideration, I have concluded that the Paulson Plan is most likely intended to do the wrong thing. However, no matter which turns out to be the case, the government can afford it.

UPDATE: Upon further consideration, I have come to doubt whether it is even possible to implement the Paulson Plan in a way that doesn't effectively give banks more capital for free. For perfectly rational economic reasons, severely undercapitalized banks would rather hold on to illiquid assets and risk failure than sell those assets at fair value and admit the true extent of their undercapitalization. A better plan would require forcing banks to accept fair value.

That said, given the severity of the crisis we currently face, the Paulson Plan is probably better than doing nothing. But surely doing nothing is not the only alternative.

I Changed My Mind

2008-09-21T20:04:00.005-04:00

By definition, the fair price of a risky asset is one that allows a high return. Therefore, if the Treasury intends to buy distressed assets at a fair price, it must intend to get a high return, which is to say, it must intend not only for the taxpayers to make a profit, but for them to make a large profit. If the Treasury doesn’t intend to pay a fair price, then it is intending to recapitalize banks by giving away money without receiving any equity participation, which is merely a program of welfare for the rich. Thus, either the Treasury intends for taxpayers to make a large profit, or it intends to engage in a program of welfare for the rich. Which is it?

I just looked at the Congressional map, and it turns out that Barney Frank is not my Congressman. He is from my state’s Congressional delegation, though, and I think he represents the district in which my vacation condo is located. Anyhow, here’s the question I would like him to ask Hank Paulson:

Do you intend for this plan to be highly profitable for taxpayers? Mind you, Mr. Secretary, I don’t mean that your intentions will necessarily be realized. I know there is a lot of risk, and even if you intend for taxpayers to make a large profit, they may end up losing nearly the whole $700 billion. But I’ll repeat my question: Do you intend for this plan to be highly profitable for taxpayers?

Unfortunately, when I do this thought experiment and consider the possible outcomes, my estimate of the expected value of the Secretary’s answer contains only about 10 basis points of “yes.” There are 90 basis points of “no,” and the remaining 99% consists of not really answering the question. Of course one can press him if he gives a weasely answer, but most successful people in the District of Columbia are very good at continuing not to really answer a question when they are pressed for an answer.

So we have to guess why he doesn’t want to answer the question. Is it because he doesn’t want to get people’s hopes up by admitting that this Plan is intended to make a large profit when he knows that outcome is subject to risk? Or is it because he intends to overpay for the distressed securities with taxpayers’ money? In my estimation, most of the weight of probability goes to latter motive.

I should also say that I’m becoming increasingly skeptical about the proposed mechanism for setting prices. In principle, if the mechanism results in the Treasury repeatedly taking losses on the securities, it should be replaced with a better one, but I worry that it will not be. The problem with a reverse auction is that bankers who have taken inadequate write-downs on their distressed assets, and who are already undercapitalized on their books, may have little incentive to make fair bids.

This is essentially the usual moral hazard problem for corporations. Bankers facing a potential endgame have no incentive to protect their creditors (or depositors, who are mostly FDIC-insured anyhow). If they run out of capital, even if they just barely run out of capital, that’s the worst case outcome. If they run out of capital and end up deeply in the red, that outcome is equivalent from the banker’s point of view.

From a creditor’s point of view (or from the FDIC’s point of view, in the case of most commercial banks), the optimal action is to take a fair price for the security even if that uses up all your capital. From the banker’s point of view, the optimal action is to gamble on the possibility that the fair value of the security will later rise to its book value or higher. That way you have at least a chance of coming out ahead. But you’re gambling with creditors’ money (or with the FDIC’s money). If the gamble doesn’t pay off, the value of the asset goes down, you end up in the red, and your creditors (or the FDIC) are stuck with the bill. Thus the banker has no incentive to bid fair value: instead she will bid book value, or possibly even more. If the bid wins, she gets a windfall. If the bid loses, she gets to gamble with creditors' money. But if she bids fair value, she is assured of losing.

Accordingly, while I stand behind the logic of my "Bailouts for Fund and Profit" post, and I continue to bristle at the suggestion that liquidity is not really an issue, I have concluded that the actual primary purpose of The Plan is recapitalization at taxpayer expense. Accordingly, until such time as my vacation condo’s Congressional representative should actually ask my question and get the “yes” answer or something roughly equivalent, I am herewith withdrawing my support for The Plan. As per my "Recapitalization" post, it is the wrong plan.

Illiquidity and Uncertainty

2008-09-21T19:22:00.005-04:00

My next post is going to go in a very different direction from my earlier ones, but for now I want to make a point about liquidity. People are telling me that the liquidity issue is bullshit, but they’re wrong, and here’s why.

Mortgage securities have ratings. A couple of years ago, investors thought that those ratings meant something. Given that belief, they were able to outsource most of their research to Moody’s, Standard & Poor’s, and Fitch. That was (or would have been, if it had actually been working) very efficient, because it avoided a lot of duplication of effort in the analysis of difficult, complex securities. Based on the ratings, investors were able to ascertain with a reasonable degree of precision how much they were willing to pay for the securities. Consequently, there were a lot of investors willing to buy and sell the securities, and the market could produce narrow bid-ask spreads.

But sometime in 2007, investors suddenly realized that the ratings were complete crap. Moody’s, Standard & Poor’s, and Fitch were not doing a good job with their research, or at least they weren’t doing the job investors had thought they were doing. Now that ratings were no longer considered useful, the pricing of these securities required a tremendous amount of research by each investor considering buying or selling one of them.

So an investor contemplating buying one of these securities has 3 options: she can forget about it; she can put in a lowball bid just as a shot in the dark, on the off chance that it gets picked up by some desperate seller; or she can devote a lot of resources to figuring out how much the security is really worth to her, and then put in a bid that might have a decent chance of being accepted. Considering all the other possible uses she has for her resources, she is unlikely to choose what's behind door number 3.

Similarly, if an institution owns one of these securities, it has 3 choices: it can hold on to the security; it can take the best bid available, in which case it will almost certainly be selling the security for less than it is worth (if indeed it can sell it at all); or it can devote a lot of resources to figuring out how much the security is really worth to it, and then offer it at a reasonable price which has almost no chance of being accepted, since potential buyers were not willing to do that research and therefore don’t know what the reasonable price is and won’t be willing to pay it. Essentially, except under forced liquidation, options 2 and 3 make no sense. The only reasonable thing to do is hold on to the security. That is illiquidity.

One of the potential advantages of government involvement is that the government should be able to do the necessary research with reasonable efficiency. As a huge, huge potential buyer, the government isn’t wasting its resources by doing a large amount of research just to value one little security. If it intends to buy up an entire tranche, it can afford to expend the resources necessary to figure out how much that tranche is worth.

Unfortuantely, the more I read and think about The 700 Billion Dollar Plan, the less I think that is what the government actually intends to do. More later.

Recapitalization?

2008-09-21T17:15:00.004-04:00

I was all set to write another post about “The Great Bailout,” but apparently Paul Krugman has already said about half (the more important half) of what I wanted to say, so I’ll outsource, with my own comments interspersed to supply the other half. Prof. Krugman is leaning against the plan, and I’m generally in favor of it, but our primary concern is essentially the same. I yield the floor:

What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.
First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. [I'll quibble on whether it was actually a housing bubble or just a credit bubble, but it doesn't really matter.] This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

I think Prof. Krugman has missed a couple of things here. Deleveraging and undercapitalization are important, but they're not the whole story. A couple of other important problems, possibly more important, are illiquidity and uncertainty.

Many asset prices are declining, but that’s only part of the story; in many cases the asset prices simply don’t exist, because buyers and sellers cannot agree on a price. To put it in market terminology, there are very few bids, and there are few offers to sell, and there is a wide price spread between what bids and offers there are. Since nobody really knows what these assets are worth, buyers are not willing to take the risk that they may be paying too much, and sellers are not willing to take the risk that they may be asking too little. As a result, these assets are frozen on the books of banks, and the banks have difficulty raising cash when they need it.

Moreover, because nobody really knows what these assets are worth, nobody knows what the asset-holders are worth. Even if you have all the detail of a bank’s balance sheet, you still can’t tell whether the bank has enough capital or not, because you have only a wild guess as to whether the assets on the balance sheet are being fairly valued. This uncertainty makes it impossible to tell a good bank from a bad bank. Since almost any bank may turn out to be bad, banks are afraid to lend to one another.

Continuing with Prof. Krugman:

So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

OK, but, if you notice, the plan, provided that it turns out to be large enough, pretty much solves the other two problems that I mentioned. (Well, in a sense it doesn't solve the uncertainty problem; it just makes it the government's problem instead of the private sector's problem. But that's OK with me, because I'm confident that the government is a good bank, given that it has the option of printing new money if it runs out.)

With the illiquid assets off the banks’ books and replaced with liquid, easily valued assets like Treasury bills, illiquidity and uncertainty are no longer a problem for the banks.

OK, now comes the main point I wanted to make, before I was scooped by the Professor:

Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk. [Italics his; bold mine.]

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?

Hit the nail on the head: if the purpose of the plan is to recapitalize banks, then it is the wrong plan. The right plan, as we have already seen in the case of AIG, is for the Treasury (or the Fed) to take equity positions in the undercapitalized companies.

I support Secretary Paulson’s plan if the purpose is to provide liquidity, resolve uncertainty, and end the vicious circle of deleveraging. But, I repeat, if the purpose is to recapitalize the banks, then it is the wrong plan. In effect, the government would just be giving away money – a blatant example of welfare for the rich. If a company needs capital and comes to me for help (well, assuming I had about 100 times as much money as I actually do), I’m happy to consider buying into a stock offering if I think the price is fair. I’m not going to just give them money as an act of charity. And neither should the government.

Possibly, banks that need capital will be pig-headed and continue the financial meltdown by refusing to accept capital on reasonable terms. If that happens, then it may be time to consider the very drastic step of forcing them to accept capital on the government’s terms. Nationalization. Socialism. If it comes to that. That certainly would not be my preferred outcome, but at least it should be a credible threat.

Why the Cost of the Bailout Doesn’t Matter, part 1

2008-09-21T11:14:00.002-04:00

Let’s suppose that, as some people seem to insist, the government will not recover a cent from the distressed assets it buys in the big bailout. What will the bailout cost the taxpayers?

As I argued in my previous post, it will not cost today’s taxpayers anything. But what will it cost future taxpayers? I suggested in my last post that perhaps the government could roll over its debt indefinitely, and no taxpayers would ever have to pay it off. That might sound ridiculous at first blush. You will say, perhaps, that investors will be unwilling to refinance the debt once they catch on to the government’s strategy of rolling it over forever. I would agree, if the result of the rolling over the debt were a debt-to-revenue ratio that went up over time. In that case, investors would see that the rollover strategy was unsustainable, and they would refuse to lend. But, I will argue, we should not expect that to be the case. In all likelihood, provided that the primary deficit (i.e. deficit before interest payments) can be brought under control in subsequent years, the debt-to-revenue ratio will fall over time.

The key to my argument is that the long-term growth rate of the economy should be higher than the (expected long-term average) interest rate paid by the government. In that case, revenues will keep rising at a growth rate that is higher than the interest rate, so if you discount those revenues at the interest rate, the present value of the stream will be infinite. Thus the government effectively has infinite assets, so whatever debt it takes on, it can keep rolling over that debt and financing the interest payments with new debt, and the debt will still be a smaller and smaller multiple of revenues every year.* (This works as long as the new debt is a one-time thing. If the government keeps running large primary deficits year after year, then its debt may grow more quickly than its revenues, and that would be unsustainable.)

But will the growth rate be higher than the interest rate? Yes, I will argue, it normally will be. My argument relies on the premise that most capital income is reinvested. It’s reasonable to expect that most capital income will be reinvested, since people saving for retirement will typically reinvest their capital income and then add some new savings, whereas retired people will consume their capital income to an extent likely to roughly offset the extra saving by younger people. (OK, I'm working on a better argument, and I'm sure there is one that somebody has written a paper about -- probably a paper I read years ago and then forgot. Actually several arguments, each of which has produced several papers, all of which I either have not read or have forgotten. But let this argument do for now. In any case, to me, it seems intuitively likely that most capital income will be reinvested.)

If capital income is reinvested, then the growth rate of capital (due to that reinvestment) will be equal to the return on capital (which provides that income). In a steady state, by definition, the growth rate of capital has to equal the growth rate of labor. The economy will always tend toward that steady state because, if capital is growing faster than labor, then the amount of capital per worker is growing, which means that the return on capital must be falling (since over time, every unit of capital has less and less labor to work with and therefore becomes less productive), which means that the growth rate of capital must be falling, so it will eventually fall to the growth rate of labor. (That argument applies in reverse if capital is growing more slowly than labor.)

So here’s why the growth rate will be higher than the interest rate. The overall return on capital, as discussed above, should roughly equal the growth rate. At the level of the whole economy, there is a capital structure, where some capital is risky and has a high return, while some is safe and has a low return. Since government bonds are the safest type of capital asset, they have the lowest return. That means that the average return on capital across the economy must be higher than the return on government bonds. Since the average return on capital roughly equals the growth rate, that growth rate must be higher than the return on government bonds. Thus the growth rate is higher than the interest rate paid by the government.

Consequently, the government, in effect, has, in the capitalized stream of future tax revenues, an infinitely valuable asset, which it can put up as collateral for anything it wishes to borrow, no matter how much. It will only be a problem if the borrowing is perceived as part of an ongoing pattern, in which case the government’s asset will no longer be infinitely valuable (since future revenues have to be sufficient to pay off not only the current debt and its interest, but also all future primary borrowing, which, in the “ongoing pattern” case, is expected to be too much for the expected revenue stream to ever pay off).

Maybe you think that we are in the “ongoing pattern” case, since the government has been running fairly large deficits for several years now. Personally, however, I believe that these primary deficits will, at least in the short run, come under control. We will either have a Democratic president who promises policies to raise tax revenues, or we will have a Republican president who will be working with a Democratic congress and will thus have great difficulty extending the expiring tax cuts or instituting major new expenditures. In the longer run, we do have to worry about the effect that an aging population and rising health care costs will have on entitlement programs. I’m worried about that, but I’m not much more worried than I was a week ago.

Now, perhaps you will try a reductio ad absurdum by saying, “If any amount of one-time borrowing can be financed by rolling over the debt indefinitely, why stop at $700 billion? Why not borrow $700 trillion? Or $700 quadrillion?” It does get absurd when the numbers get ridiculously high, because it gets to the point where the debt will be huge relative to revenues and it will take a ridiculously long time before revenues catch up. In other words, mathematically speaking, the present value formula (which gives the value of the government’s revenue stream) is not very useful if it takes many centuries for the cumulative sum to come close to its theoretical limit. But with the national debt already well into the trillions, and with investors obviously willing to refinance the current debt at very low interest rates, I seriously doubt that another $700 billion – or even another $2 trillion, should it come to that – will make the difference between a reasonable level of debt and an unreasonable one.

Yes, Virginia, when it comes to financing government bailouts of financial assets, there is a Santa Claus. I should make clear, though, that Santa Claus is not omnipotent. He can come down the chimney and deliver a financial bailout on Christmas Eve, but he can’t make something out of nothing. If the government were to attempt some type of bailout that involved the production of large quantities of real goods and services, Santa Claus could only help to the extent that the economy had slack resources (as it does now and likely still will in the immediate future, but probably only a few hundred billion dollars worth, at most). When the economy runs out of resources, no bailout can make more of them.

*See Michael R. Darby, “Some Pleasant Monetarist Arithmetic,” for a more precise version of this argument in a different context.

Bailouts for Fun and Profit

2008-09-21T02:13:00.004-04:00

OK, this pisses me off. David Stout, writing a Q&A in The New York Times (“The Wall Street Bailout Plan, Explained”):

Q. Who, really, is going to come up with the $700 billion?

A. American taxpayers will come up with the money, although if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion. After the Treasury buys up those troubled mortgages, it will try to resell them to investors. The Treasury’s involvement in the crisis and the speed with which Congress is responding could generate long-range optimism and raise the value of those mortgages, although it is impossible to say by how much.

First of all, today’s taxpayers are certainly not going to come up with the money, not by any stretch of the imagination. There are no plans to raise taxes to pay for this bailout, nor, in my opinion, should there be. (That’s not necessarily to say that taxes shouldn’t be raised, just that this bailout should not be the deciding factor.) People (and institutions mostly, really) who buy Treasury securities will come up with the money. The Treasury will issue new Treasury securities to raise the money to pay for the distressed securities that it buys. Most likely the banks that sold those distressed securities will buy the new Treasury securities with the proceeds from the sale, so nobody really has to come up with the money, except for a few minutes while the deals are being done. In effect the Treasury will be paying for the distressed securities by creating its own securities to use as payment.

Someone is going to say, “Well, of course today’s taxpayers aren’t going to come up with the money, but the Treasury securities eventually mature and have to be paid off, and when that time comes, those future taxpayers will have to come up with the money.” I will attack that straw man immediately by pointing out that the debt can be rolled over. Maybe eventually, after rolling over the debt several times, the government will be forced by circumstances to raise taxes to make those payments. But maybe not. I’ll have to do another post on why the “maybe not” case is more reasonable than you might think.

But let’s suppose that those Treasury securities do eventually have to be paid off with taxes and cannot be rolled over indefinitely. Does that mean that future taxpayers will have to come up with $700 billion plus interest? There is a tiny chance that that will be the case. Which brings me to what mostly pisses me off. I repeat from above:

...if you are bullish on America in the long run, there is reason to hope that the tab will be less than $700 billion.

Reason to hope? That the tab will be less than $700 billion? Holy crap! I would sure as hell hope that at least a few of the mortgages in the pools bought by the government don’t default! OK, I’m being a little disingenuous, since much of what the government buys will be lower tranches that can become worthless even if there are only a moderate number of defaults. Some of the securities very likely will become worthless. But in all probability, unless there is a severe, prolonged recession (which is to say, a depression) and a much further decline in housing prices, the government’s whole portfolio will still be worth something.

And – here’s my main point – the Treasury will not be paying full price for these securities. It won’t be paying anything remotely close to the price that the securities were issued at. It will be paying whatever price desperate banks are willing to accept in order to get the securities off their books and replace them with things that can be easily sold when they need cash. These are motivated sellers we’re talking about. In all probability, many banks will be willing to sell these securities for less than they think the securities are really worth. Because they don’t want to take the risk that, when the government bailout is over, they will have some need for cash and won’t be able to sell the securities then.

Granted, there may be some banks that figure out ways to game the system and sell their securities for more than they are worth. But all in all, we should expect the Treasury to get these securities at something close to fair value. The Treasury is not just throwing money away; it’s buying valuable (though quite risky) assets and paying roughly what those assets are worth. [EDIT: I was wrong about this, because I didn't take into account the moral hazard faced by bankers who can fudge their asset values. I discuss this among other topics in the post where I change my mind about the bailout. It is still true, though, that the Treasury will not be paying full price, and it is likely to recover much of its investment and possibly even turn a profit, but unfortunately not a large enough profit to justify the risk.]

And it’s important to understand that “fair value” includes the expectation of a substantial risk premium. The fair value of a junk bond is considerably less than the fair value of an otherwise similar investment grade bond, but when they mature, both bonds are redeemed at par. The junk bond has a larger chance of default, but even when you take that chance into account, the expected return on the junk bond is considerably higher. People don’t buy junk bonds because they’re stupid; they buy them because they expect, on average, a high return. Similarly, the Treasury should expect, on average, a high return from its purchases of distressed securities.

So, while there is (in theory, at least) quite a large risk to (future) taxpayers (a risk of up to $700 billion – plus the meager interest that the government has to pay), the expected return is not only positive but rather large. And since the interest paid on Treasury securities is quite small, that return, if it materializes, will be a huge windfall for whatever future taxpayers get the benefit.

So this “bailout” is not about the Treasury paying $700 billion and hoping to recover some of it in a best case scenario. It is about the Treasury paying $700 billion dollars, risking losing up to the whole amount, but expecting not just to recover the entire amount but to emerge with a large profit. The Treasury is, in a sense, gambling with taxpayers’ money, but the gamble is a good bet, kind of like if you had inside information about the horse. Of course, making a profit is not the point of the operation, but it might be a pleasant side effect.

Why Short Selling Matters

2008-09-20T14:04:00.003-04:00

Arnold Kling (hat tip: Matthew Yglesias) argues that short-selling can’t “destroy a good company” because if the company is good, someone will always be willing to pay a good price for it and will be willing to buy it from the short-seller at that good price. But his analysis fails to account for uncertainty and imperfect information. We don’t really know which companies are “good.” Everyone has their own guess about how much a company is worth, but how much is it really worth? We won’t know until we see its results. Actually, we won’t even know then, because it will have more results in the future that we still won’t know about.

In general, since the market value of a company depends on an uncertain guess as to its true value, a good company can be destroyed simply by bad opinions, if people wrongly judge that it is a bad company. And, as I will explain, short-selling can exacerbate this problem in the case of a company that is in fact good but that, in terms of market opinions, is on the margin between being considered good and being considered bad. The “margin” idea applies when there is only one “marginal” short seller, but if there are many, they will effectively widen the margin, so that a clearly “good” company can turn into a clearly “bad” one.

For any given company, the market does not have one opinion, shared by everyone, about the value of its stock. Rather, everyone has a different opinion. People use different methods (including subjective ones, which differ from any one individual to another) to evaluate a stock. Those different methods lead to different conclusions about the stock’s value. One person may think a stock is worth $10; another may think it’s worth $9.99; another may think it’s worth $9.98; and so on down, and maybe, at the other extreme, there is someone who thinks it’s only worth $2.

So suppose the stock is trading at $10, and a large short-seller appears on the scene. The short-seller will satisfy the demand of the person who thinks the stock is worth $10, and then there will be no more demand at $10, and the stock will trade down to $9.99. Then the short-seller (who is, by my construction, “large”) will satisfy the demand of the person who thinks the stock is worth $9.99. Then the stock will trade down to $9.98, and the short-seller will satisfy the demand of the person who thinks it’s worth $9.98, and it will trade down to $9.97. And so on. If there are a lot of large short-sellers, they can bring the price down by quite a lot by, for example, satisfying the demand of everyone who thinks the stock is worth more than $7.

So let’s take that $10/$7 example, and let’s suppose that the definition of “good” requires the stock to be worth $8 or more (in a sense that will become more precise in later paragraphs). By sending the price down from $10 to $7, the short-sellers have effectively shifted the company’s “market reputation” from the “good” category into the “bad” category. No individual has actually changed their opinion, but because of the aggressiveness of the short-sellers (who obviously believe the company is quite a “bad” one), the “market” has changed its “collective opinion.”

Now let’s suppose that the company is (in actual fact rather than opinion) a “good” company but that it needs to raise more equity capital in order to stay good. (When you’re talking about a bank that is solvent but undercapitalized, this might be a reasonable description.) When it offers new shares, the company faces the same demand curve as the short-seller did, and since the price is now down to $7, the company will have to offer the shares at a lower price, say $6, for the offering to be fully subscribed, because it will satisfy the demand of everyone who believes the company is worth $7, $6.99, $6.98, and so on, down to $6.

OK, but suppose that the amount of capital raised at a $6 share price will not be enough to keep the company good. And let’s also suppose that it would have been enough if the offering price had been $9, which it would have been (approximately) if the short-sellers had not become involved. So the company still doesn’t have enough capital, and it needs to raise more. So it offers more shares. But again, the company faces a downward-sloping demand curve for its shares. Suppose it offers additional shares, which satisfy the demand of everyone who thinks they are worth more than $5, so the company offers these new shares at $5. But suppose that still is not enough to keep the company good. It has to offer more shares. But now that it has done two separate offerings, and it attempts a third, it probably won’t have the confidence of the market. Market participants will say, “If we pay $4 now, who is to say that the company won’t come back and offer shares at $3? We’ll wait for that.” And if they wait for $3, why not wait for $2? And if $2, why not $1? Of course at some point everyone is going to realize that the company is going to be unable to raise sufficient capital at any price.

In practice, potential buyers will have realized that much earlier. If they have a reasonable guess as to how much capital the company needs, and a reasonable guess as to what the demand curve for its stock looks like, then they will be able to come up with a reasonable guess as to whether the company can raise the necessary capital. Of course, there will be a variety of guesses, and opinions will differ. But at some point (as the declining stock value makes the problem clearer), only a few people (or none at all) will be of the opinion that the company can raise enough capital. At that point, the company is effectively ruined, the price goes down to near zero, and the short-sellers profit handsomely. If there are enough large short-sellers, not only can they destroy a good company, they can make a lot of money doing it.

UPDATE: Another way to argue that short-selling doesn't matter would be to argue that the person with the $10 opinion has an infinite amount of capital available, and therefore they will demand an unlimited number of shares at $10. Of course, it's rather silly to think that anyone has infinite capital. And for someone with limited capital, the more they pay for the shares, the more risk they are taking. So they will be willing to buy a certain number of shares at $10, but after that, the risk become too high, and the price has to go down to get them to buy more. Essentially, my argument above still applies, except that you can construct the demand curve from just one person's opinion. If there are many potential buyers, each of whom has limited capital and limited risk tolerance, but who have different opinions, the demand curve will still slope downward, and again my argument applies.

WSJ Factual Error

2008-09-18T00:00:00.008-04:00

From the top story in today’s Wall Street Journal:

At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured....That’s never happened before.

Actually it has happened before, not in the easily available data, but it has happened – in 1938 (and apparently several other times between 1935 and 1941).

My only source is a talk by Paul Samuelson, for which I cannot even point to a transcript, but I’m confident that primary sources will bear me out. I’m too lazy to go check old copies of The Wall Street Journal on microfilm, but take my word for it.

It’s actually pretty obvious if you look at the monthly data from the Fed. For example, in February 1941, the average yield on 3-month T-bills was 0.03 percent. Considering how the yield fluctuates from day to day and from hour to hour, it’s impossible to believe that it was not negative at certain points during that month. (Technically the Journal was referring to one-month bills, but it’s a safe assumption that, if 3-month bills were selling above maturity value, so were one-month bills for at least part of the time.)

UPDATE: Paul Krugman makes the same claim (hat tip: anonymous commenter)....and I continue to believe it is wrong. I'm not sure his claim is independent: he may have gotten his information from the Journal, or they may have gotten it from the same source, which I hope they will cite so we can follow it up and judge its reliability.

UPDATE2: Reuters and the AP, both citing Los Angeles-based Global Financial Data, report that the last time the 3-month T-bill was at or below zero was January 1940. (Could it merely have been "at" zero? It seems unlikely that the bid would have stopped at exactly zero.) Another AP report says that demand sent "the yield on the 3-month Treasury bill briefly into negative territory for the first time since 1940." Friedman and Jacobson, in A Monetary History of the United States, 1867-1960, say in a footnote that "yields on Treasury bills were occasionally negative in 1940." (Apparently my "obvious" conclusion about 1941 was not correct, buy my main point stands.)

How many people have lost their jobs?

2008-09-18T00:00:00.004-04:00

According to Barack Obama, 600 thousand Americans have lost their jobs since January. Actually, he's wrong: something like 20 million Americans have lost their jobs since January. It's just that most of them found new jobs. Probably the new jobs generally weren't as good as the ones they lost. And almost certainly, more than 600 thousand of them were unable to find new jobs, because many of the new jobs created were filled by new entrants to the labor force or by people who were already unemployed when the year began.

Like almost everyone else I've ever heard, Senator Obama is making the mistake of using a net job loss figure with language that, if taken in its plain sense, clearly implies he is talking about gross job loss. And it seems to me that gross job loss is the appropriate concept: losing your job is a pretty serious bummer, even if you are able to find a new one after a few months.

There has been a lot of talk about Senator McCain and how he has been saying things that aren't true in order benefit himself politically. It turns out that Senator Obama is also (obviously unintentionally) saying things that aren't true, but in this case they benefit his opponent.

Moral Hazard for Corporations, part 2

2008-09-17T00:22:00.003-04:00

I agree with Mark Kleiman's main points here, but this one, as my previous post would suggest, I think is a mistake:

Why shouldn't the government bail out a private company that isn't a regulated bank? Moral hazard. You don't want to protect AIG shareholders from the consequences of the bad bets made by the management, or you offer every big firm the chance to gamble on a "heads I win, tails you cover my losses" basis.

(Just to be clear, he isn't defending his own overall position with that statement; he's just discussing one consideration to be weighed.) As I argued in my previous post, whether or not any "bailout" is attempted, the shareholders are automatically bailed out by the limited liability that is part of the definition of a corporation. In a failure, their stock might become entirely worthless; in a bailout it just becomes almost worthless -- not an important distinction. Prudent stockholders have portfolios of stock, so it's not like a stockholder is someone who will personally be left with nothing in the case of a failure but still have a little bit to keep in the case of a bailout. Typical stockholders will just see changes in the values of their portfolios, and the difference between a 90% drop and a 100% drop in one stock will make only a tiny difference to the value of the portfolio.

Mark Kleiman goes on to discuss the role of moral hazard for creditors, and of course that is the real story. Since stockholders have limited liability, they always have an incentive to take excessive risks, unless the creditors prevent them from doing so (usually by threatening to withdraw credit). The real reason for avoiding bailouts is that the prospect of a bailout takes away the creditors' incentive to provide discipline. OK, I'm not going to repeat more of what I've said like three times already, and I'm not going to quibble with the subsequent wording of the post that I cited. It's worth reading for itself, although the argument is not too different from what I've been saying in recent posts.

Moral Hazard for Corporations

2008-09-16T11:05:00.002-04:00

With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Take, for example, the aphorism (regarding deposit insurance), “Heads stockholders win, tails taxpayers lose.” (This aphorism was recently used by, and may have been coined by, Paul Krugman. To be fair, if you read his whole entry, the language is more precise when he discusses the matter explicitly. But he also uses the misleading expression – which he did not coin – “FDIC put.”) This makes it sound as if deposit insurance were somehow protecting stockholders from the consequences of risky actions taken on their behalf. But what if there were no deposit insurance and the same risky actions were taken? What would happen to stockholders if those risks turned out badly? The stockholders would lose what they put into the corporation but no more – exactly the same as when there is deposit insurance. The moral hazard problem exists in general with stockholders, whether or not the assets are insured, because of the limited liability inherent in the corporate form of ownership. There is no “FDIC put” for stockholders; there is merely the “corporate put” that exists for all corporations.

When we talk about corporations whose assets are insured, either explicitly or implicitly, the special moral hazard problem is not with stockholders but with creditors. In the case of commercial banks, the creditors are known as depositors. The problem with deposit insurance is that it takes away the incentive that depositors would have to select and police their banks in such a way as to prevent excessive risk-taking. Overall, in the case of commercial banks, removing this incentive is a good thing, because depositors – with limited information and resources – aren’t able to do a very good job of policing and selecting banks. Their attempts to identify “bad banks” often result in “false positives” that precipitate bank runs. It makes much more sense to have regulators – who have more resources and better information – do the policing.

So I’ll repeat the point I’ve made several times before. When we talk about the implicit insurance that is (apparently not, as of yesterday) offered to investment banks and the like, the issue is not whether the stockholders are being protected – they’re always protected by the rules of corporate ownership – but whether the creditors are being protected. Are creditors being encouraged to make rash decisions about where to lend their money? Is the process of avoiding those rash decisions (as in the case of commercial banks) an inefficient one that could be done better by someone else (regulators, presumably)?

I have argued that, in the case of major investment banks, the moral hazard for creditors should not be a major concern. The comments have convinced me that I may have overstated my case, but I stand behind the policy recommendation. (Well, a “recommendation” after the fact is known as a “criticism,” but I would have recommended the same thing before the fact. The main reason I didn’t talk about it before the fact is that I expected officials to do what I would have recommended anyhow.) Large investment banks can, and perhaps should, be allowed to fail sometimes, but not when the country is already in the midst of an ongoing financial crisis and interest rates are low enough to limit the potential for using monetary policy to blunt the economic effects. Creditors should perhaps take the risk of losing their investment during generally good times, when the effect on the economy would not be potentially disastrous. I’ll reserve judgment as to whether creditors should be (implicitly or explicitly) insured (and I will certainly agree that such insurance should come with additional regulation), but I will not retract my opinion that the financial system as a whole should be insured. Sometimes implementing insurance for the system as a whole requires that individual institutions be bailed out.

Third Rant of the Day

2008-09-15T20:13:00.004-04:00

When it rains, it pours. This one is really sort of a repeat of my first rant, but with more explanation and less sarcasm. Well, more explanation, anyhow.

Here’s Treasury Secretary Paulson at a press briefing this afternoon:

I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.

When I first read this, I interpreted it to mean, “I never once considered the possibility that it was appropriate...,” and I was ready to write a somewhat more obnoxious rant about how Paulson was either a liar or irresponsible, and I hoped he was a liar. But a more careful parsing reveals that he is neither lying nor being irresponsible; he is just engaging in doubletalk. I don’t fault him for that, since it’s pretty much part of the treasury secretary’s job description. He never considered it to be the case that it was appropriate to put taxpayer money on the line.

Secretary Paulson is drawing his macho line in the sand and saying, “See, Mr. and Mrs. Average American, who faithfully pay your taxes, I’m protecting your money from the whining Wall Street plutocrats. So never think that just because I came from Wall Street, I will put Wall Street’s interests above those of Main Street. And never say that Republicans always help the rich.”

Which is fine if you believe that financial events have no impact on the nonfinancial economy. But most economists (and, I would guess, Secretary Paulson himself) don’t believe that. Let me assert – and see whether I get broad disagreement – that the failure of the 4th largest investment bank in the country can be expected to increase significantly the risks faced by participants in the nonfinancial economy. In particular, when the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

But then there is also the question of whether even “taxpayer money” is really less on the line than it would be if the Treasury had provided loan guarantees. I’ve addressed this question before in connection with the Fed’s Term Securities Lending Facility. Each individual taxpayer who benefits from public services depends on the taxes collected from all the other taxpayers to help pay for those services. If the other taxpayers start losing their jobs, tax receipts will go down, and this taxpayer will eventually have to pay more taxes, or give up more public services, to make up for that loss. If you risk the potential economic effects of a major investment bank failure, you are risking that taxpayers will have to pay higher taxes. That’s just the same as if you had provided loan guarantees, which risk that the loans will go sour and require an increase in taxes to make up the difference. In which case is the risk bigger? Not obvious to me, but if I had to guess, I would say that the investment bank failure risks taxpayer money more than would the loan guarantees. So I would say that Secretary Paulson’s stance on “taxpayer money” is either politically disingenuous or economically naïve.

Let’s consider the possibility that it is politically disingenuous and that his motivation is actually something different than protecting taxpayer money. I’m not suggesting anything sinister; I’m just suggesting that there is a (slightly) more reasonable, but harder to explain, argument for avoiding a bailout. As Secretary Paulson says elsewhere in the briefing:

Moral hazard is something I don't take lightly.

Rather than trying to define moral hazard, I’ll go with the definition used by the AP in the report about the briefing: “the belief that when the government steps in to rescue a private financial firm it encourages other firms to engage in risky behavior.”

But does it? When the government steps in to rescue a firm by facilitating its sale at a small fraction of the price that it fetched a year or two ago, does that really encourage other firms to engage in risky behavior? It’s kind of like when your health insurer requires only a $950 co-payment for a $1000 procedure. Does that give you an incentive to make excessive use of the health care system? If I were a financial firm contemplating engaging in risky behavior, I wouldn’t find the prospect of a fire-sale rescue to be very encouraging.

It’s really not the firm that would be bailed out, but the firm’s creditors. Were the creditors engaging in risky behavior that needs to be discouraged? There isn’t much I can say about that that I didn’t already say this morning. In general, I think that doing business with major investment banks is something that we should encourage. A financial system doesn’t work very well when everyone is afraid to do business with everyone else. Should counterparties really be expected to do extensive due diligence on the 4th largest investment bank in the country before they engage in credit swaps with it? It seems to me that would not be a very efficient use of resources. And in any case, it’s not clear that even extensive due diligence would have uncovered the depth of Lehman’s problems.

End of rant. Executive summary: They should have bailed out Lehman.

Careless, Disingenuous, or Just Ignorant?

2008-09-15T13:55:00.010-04:00

Donald Luskin in the Washington Post:

Obama is flat-out wrong when he frets on his campaign Web site that "the personal savings rate is now the lowest it's been since the Great Depression." The latest rate, for the second quarter of 2008, is 2.6 percent -- higher than the 1.9 percent rate that prevailed in the last quarter of Bill Clinton's presidency.

That sounded a little strange to me, so I checked the national accounts. It's quite true that the savings rate is 2.6 percent in the second quarter of 2008, but the average of the last 4 quarters is less than 1 percent, and in most of the recent quarters it has been 0.5% or less -- which certainly qualifies as "the lowest...since the Great Depression."

Have US households suddenly seen the light and started saving again? A slightly closer look at the national accounts shows where that light shined from. The only thing unusual about the second quarter of 2008 was a sudden drop in "personal current taxes," which resulted in an increase in "disposable personal income," the denominator for the savings rate. Ah, yes, that's what had slipped my mind (and perhaps Mr. Luskin's as well) about the 2nd quarter. (If the reason for the drop in taxes isn't immediately apparent, you might want to check the headlines for January 24. But I'm guessing that rebate check didn't come as a surprise.)

Apparently Americans thought it might be better to save some of of the "stimulus" money for, say, the 3rd quarter or the 4th quarter...or even next year? So, yes, the savings rate did go up. That's one of the usual results of a fiscal stimulus. In fact, a fiscal stimulus is exactly how Franklin Roosevelt managed to get the savings rate back into positive territory during....what was it?...oh, yeah, the Great Depression.

Perhaps Mr. Luskin was in a hurry and didn't notice what the savings rate was in other recent quarters. Or perhaps he was deliberately using a true but misleading fact. Or perhaps he just didn't understand why the savings rate had suddenly risen. Based on past experience with Donald Luskin, I tend to go with the last explanation. I have no particular reason to question his diligence or his intellectual honesty, but his understanding of economics often seems weak, even when the points in question are fairly basic.

Apparently Mr. Luskin now hopes to have some political influence:

I'm an adviser to John McCain's campaign, though as far as I know, the senator has never taken one word of my advice.

If John McCain has indeed never taken any of Donald Luskin's advice, that speaks well for the senator's judgment.

Moral Hazard and Protecting the Taxpayer

2008-09-15T08:39:00.004-04:00

What? You've been doing business with the 4th largest investment bank in the country? How imprudent of you! We can't allow such rashness to be rewarded. No, we must let the market punish you for your imprudence. Otherwise, it will encourage people to do such risky things in the future -- expecting the risks to fall on the taxpayer.

Yes, it is the taxpayer that we are trying to protect. The taxpayer cannot accept the consequences of your imprudent actions. Never mind that, given the possible economic impact, most people who pay taxes will face even greater risks than the they would if the government had facilitated a sale by guaranteeing some of Lehman's assets. The Treasury's obligation is not to the people who pay taxes. It is to the taxpayer!

Drilling makes us more dependent on foreign oil

2008-09-05T11:14:00.003-04:00

Just thought I should point out that US oil reserves are not inexhaustible, and that most of the oil in the world is still elsewhere. If we continue to feed our addiction to oil-based energy by producing more in the US, that means, when our reserves are depleted, we will end up having to feed that addiction by buying more oil from abroad. On the other hand, if we shift to other forms of energy (which unfortunately include coal), we can hopefully break that addiction and really end our dependence on foreign oil.

My title is a bit of an exaggeration, I admit. Drilling doesn't necessarily make us more dependent on foreign oil, but it doesn't make us less dependent either, except in the short run. It shifts our dependence into the future. It makes us more dependent in the sense that we will remain dependent for a longer period of time (but be less so initially).

While I'm on the subject, a nice slogan for the Pigou Club, courtesy of Al Gore, via Battlepanda:

Tax what we burn, not what we earn.

GDP Report is Good News; Deflator Critics are Wrong

2008-07-31T19:13:00.002-04:00

Some people (mentioned here, for example) are denigrating the GDP report, which appears to show a 1.9% rate of real growth, on the grounds that the deflator – used to convert from nominal GDP to real GDP – is artificially low because it doesn’t include imports (which have become more expensive, due primarily to changes in the price of one dark, viscous liquid that is included in their number). As far as I can tell, these people are confusing production with terms of trade. It’s true that the “average American” is worse off when the terms of trade deteriorate, but that isn’t what GDP is supposed to measure. And frankly, it’s not what I, as a macroeconomist, care about.

If it’s a really big deal to you that people who have jobs can’t (on average) buy quite as much with their paychecks as they could 3 months ago, then go ahead and criticize the GDP report (but be careful how you phrase your criticism). Personally, I care a lot more about the people that don’t have jobs, or potentially won’t have jobs in the future. The biggest reason that I care about the GDP report is that more production means more demand for labor. (I’m speaking in relative terms, of course. In absolute terms, a 1.9% growth rate is probably not enough even to keep employment stable, let alone absorb normal labor force growth – but this has nothing to do with the deflator.) Production increased by 1.9% in the second quarter. As far as the implication for labor demand, it doesn’t make a damn bit of difference what you could or couldn’t buy with that extra production.

The second big reason I care about the GDP report is what it suggests about trends in productivity. What happens in one particular quarter isn’t, in itself, of great consequence, but it does tend to make us revise our estimates of what will happen in the future. If productivity is growing quickly in the present, then we can be more confident about its future growth. I haven’t tried to do the calculations, but since employment fell significantly in the second quarter, productivity must have risen by considerably more than 1.9%, and that sounds like good news to me.

Again, the terms of trade are irrelevant, unless you think you can extrapolate changes in the terms of trade the same way we extrapolate productivity. Does the fact that oil prices rose quickly in the second quarter make you think they will rise more quickly in the future? Maybe according to some theories, but my theory is based on the observation that oil demand is much more elastic in the long run than in the short run. If prices rise in the short run, while demand is elastic in the long run, that means future demand is likely to decline and push prices down rather than up. Obviously that’s a limited view and an oversimplification, but you’re going to have to do some pretty fancy theoretical gymnastics to get the result that rates of oil price growth are persistent over long periods of time.

I think the 1.9% growth number is the right number to look at, and it’s better than I expected. Apparently, it is not quite as good as the consensus expected (2.3%, according to Briefing.com, as reported by Yahoo.)

But the other number you might want to look at is inventory investment, which (as James Hamilton points out in the article I linked in the first paragraph) was severely negative in the second quarter. Inventory investment is not something that can be extrapolated. If anything, it is more likely to correct after an unusual move because the move was often the result of a mismatch between planned production and actual sales. (For example, in the second quarter, the drop in inventories may have been the result of having better than expected sales, which would lead us to expect positive inventory investment in the third quarter.) Once you account for declining inventories, growth of final sales was probably enough to imply a positive growth trend for employment, once all the inventory and cyclical labor usage issues wash out. That sounds like good news to me.

Porn and Transportation are Substitutes

2008-07-06T00:55:00.006-04:00

OK, I couldn't leave this one alone. Greg Mankiw points to some research showing that "many websites focused on adult or erotic material have experienced an upswing in sales in the recent weeks" since the stimulus checks were mailed out. I can buy the theory that many of their marginal customers are liquidity constrained, which I'm guessing is the way Greg sees it, but there's another issue here that hasn't been addressed. The stimulus checks are only one of a number of things that have happened over the past few months. You might also have noticed, for example, a dramatic increase in the price of gasoline, coming at a time when people were already adjusting to dramatic increases over the past 4 years. I think that particular change is an important part of the picture.

"Adult or erotic material" is a form of entertainment, or, if you will, recreation. But unlike various other forms of entertainment and recreation, it can be consumed at home. And I suspect that a lot of people think it's more fun than most other forms of entertainment and recreation that can be consumed at home. You can go out to a bar or a club or a ball game or a movie or a show or the beach or, well, a brothel, if you're in Nevada, or you can stay home and consume forms of entertainment that can be consumed at home. I can remember seeing a story recently (I don't remember where) about how brothels in Nevada are being hit hard by the economic slowdown. If you stay home, you don't have to use up gasoline, so the relative cost of at-home entertainment goes down when the price of gasoline goes up. Adult Web sites are probably not a Giffen good, so, if we could hold other income constant, we should expect that the demand for adult Web sites should go up when the price of gasoline goes up.

Granted, other income isn't constant. The rising price of gasoline affects a lot of other areas besides entertainment and recreation, so it represents a general decline in real income. And the economy is weak. So maybe the stimulus checks compensate for these declines in income. If the effect of the stimulus checks is to bring income up to the level that it was before the increase in gasoline prices, we should expect an increase in demand for adult Web sites. So the stimulus checks matter, but it isn't just the stimulus checks.

I should give credit where credit is due. The basic substance of this idea about gas prices and porn comes from this YouTube video:

Not coincidentally, the woman in the video (Isobel Wren, whom you may remember from an earlier post on this blog) has her own Web site "focused on adult or erotic material." And in the interest of smoothing the transition to a less energy-intensive economy, or maybe just to be naughty, I'll give you the link again. (Note that it is an adult Web site, so don't click the link unless you're over 18 and your boss isn't watching.)

UPDATE: I just noticed that this video is the same one that I linked to in the earlier post. Oh, well, now you get to watch it in embedded form.

Should we develop alternative fuels?

2008-06-16T19:40:00.003-04:00

Until someone convinces me otherwise, I'm going to go with "no" -- at least if by "fuels" you mean carbon compounds that are used to release energy through combustion. Combustion of carbon compounds produces carbon dioxide, which aggravates global warming. If we're running out of oil, let's just run out, start driving less, flying less, doing less of things that produce greenhouse gases, and doing the remainder more efficiently. Or else let's find replacements that don't involve "fuels" in the sense I described: try electric cars that run on power from wind, solar power, hydroelectric power, nuclear power, etc..

From an environmental point of view, running out of oil is a good thing, an opportunity to slow down climate change, and are we now to try replacing that oil with other combustibles? When opportunity knocks, close the curtain and pretend you're not home?

If the government is going to subsidize anything, let it subsidize alternative sources and uses of electric power, or solar heating, or something like that. Why subsidize products that are going to aggravate our environmental problems?

Pigou and the Anthropophagi

2008-06-12T19:26:00.003-04:00

Why does the salmon here cost more than the chicken? There ought to be a tax on chicken.

Why?

On chicken and meat and eggs and dairy products.

Why?

Because farm animals are bad for the environment.

How?

They contribute to global warming.

How?

They produce methane, which gets in the atmosphere and adds to the greenhouse effect.

People produce methane, too, you know.

That's why I think there should be a tax on people also. Cannibals need more vegetables in their diet anyhow.

Definition

2008-05-14T15:48:00.006-04:00

Sex worker:

(1) a prostitute

(2) anyone in a sex-related occupation, including a psychiatrist with a specialization in sexual disorders or a cashier in a convenience store that rents adult videos

(3) someone in an occupational category broader than (1) and narrower than (2), the precise specification of which is known only to the person using the term

Examples of (3):

(a) Anyone who acts in an adult video, is a sex worker, but someone who works in distribution of adult videos is not.

(b) Anyone who has, on camera, actual penetrative intercourse involving an actual male member, is a sex worker, but someone who engages, on camera, in Lesbian sex acts, including those that involve penetration, is not.

(c) Anyone who interacts sexually directly with a client, whether or not that interaction includes an actual sex act, and whether the interaction is in person or over some kind of telecommunication network, is a sex worker, but someone who performs sex acts on camera, for distribution as entertainment, is not.

Supply Response and Self-Unfulfilling Recession Prophecies

2008-05-01T11:03:00.004-04:00

In a post last year, I argued that one reason economists have not successfully forecast recessions is that recession forecasts, or near-recession forecasts, prompt policymakers (usually the Fed) to act so as to prevent a recession. Only when the recession is unexpected (i.e. not forecast) will policymakers fail to act.

Spencer, an occasional blogger at Angry Bear and a frequent commenter on many different economics-oriented blogs, suggested (in a comment somewhere; I don’t remember where or when) another mechanism that operates through inventories. When manufacturers expect a recession, they reduce their inventories in anticipation, thus inducing themselves to increase production later, thereby preventing the recession they had expected. So again, a recession only occurs when it is unexpected, when manufacturers are caught with excess inventories because they hadn’t anticipated weaker demand.

Here I’m going to suggest a third mechanism whereby forecast recessions may tend to prevent themselves. The idea comes from this YouTube video, in which a model* discusses, among other things, her concerns about the weakening economy. Her response to those concerns: “I’m trying to book up as much work as I possibly can and get some savings cushions built up.”

This phenomenon may be specific to the modeling industry. Indeed, it may be specific to the particular model in the video. But I see no reason not to expect it to be more general. Intertemporally optimizing businesses, and self-employed individuals, in many service-producing industries (and for that matter, workers in all industries) may have a general incentive to shift their supply curves outward in response to the expectation of a future inward shift in demand curves. Thus the expectation of a recession would result in an immediate increase in economic activity.

I’m not sure what the full implications of this hypothesis are for the business cycle. It’s kind of the opposite of Spencer’s idea, in that here the expectation of a recession causes agents to produce more in the immediate time frame rather than less. I suspect, though, that manufacturers are better at planning at quarterly or longer horizons than are service-producing industries (and certainly individuals), so I suspect that the paring down of inventories happens well in advance of the expected recession, whereas the supply curve shift happens at about the time the recession is supposed to start. (The video example, one may note, took place in mid-April of this year, by which time many people believed that the US was already in a recession.) If the supply response is tardy enough, it could surely have the effect of preventing (or at least delaying) the recession to whose forecast it is responding.

*UPDATE: It occurs to me that I should identify the model, instead of just exploiting her as an example of a concept. Her name is Isobel Wren. She has a nice portfolio on One Model Place, and she also has her own Web site (Adults only. Not work safe.). She calls herself "the thinking man's nympho" and prides herself on being a nerd when she's not in front of the camera.

Bear Sterns

2008-03-30T11:04:00.007-04:00

I started this post last Monday and then got distracted. Looking at it now, I think the fragment is worth preserving.

I’ve spent the past week being pissed off at all the people who were pissed off about the so-called “bailout” of Bear Stearns. In the light of this morning’s [Monday the 24th] news, I’m starting to half agree with them.

Earlier, I was going to write a post about what a lucky accident it was that the current Fed Chairman is also one of the world’s foremost experts on the problems of the early 1930’s. Now I’m beginning to wonder if it would have been better to have someone with a less well-matched academic background and more poker skills.

In retrospect, it appears that the $2/share price in the original version of the Bear deal was not a real price, just a piece of propaganda, intended to give the impression that it wasn't a bailout. But it's now clear that, whether or not one calls it a bailout, Bernanke offered a lot more in loan guarantees than was really required to get J.P. Morgan to do the deal. (The $1 billion deductible on the new version of the deal is not very convincing as a concession by Morgan, and in any case, it only makes it more obvious that the Fed's original offer was much higher than it needed to be, if Morgan is willing to take a hit both on the special financing and on the purchase price.)

I don't think that's exactly a moral hazard problem, but it's the same general idea. The next time the Fed wants somebody's help to keep the financial system afloat, that somebody will know to charge dearly for that help.

UPDATE: And another thing. What the hell were Ben's priorities? If he wanted to reassure the financial markets, he shouldn't have pushed for a price that made Bear Stearns appear to be in much worse shape than it actually was. (Did that just not occur to him? Did it not occur to Tim Geithner? Did it not occur to anybody at the Fed?) If he wanted to make the Fed look tough, he shouldn't have offered way better financing terms than were really needed to get the deal done. (As noted above, both the price and the financing terms got worse for Morgan subsequently, and they were still willing to play.) Did it not occur to him that being tough with winners was important for the Fed's reputation too, as well as being tough with losers? This was a major screw-up.

Where is “Sex” in the NAICS?

2008-03-22T23:18:00.006-04:00

This business with Eliot Spitzer is bringing up issues in labor economics for me. In particular, how should we refer to Ms. Dupré’s occupation? Some people insist that she was a “sex worker.”

I have a number of problems with this terminology. For one thing, is there any other occupation where the title includes “worker” and the hourly billing rate can be in the quadruple digits? I mean, there are a few cinematic production workers who make that kind of pay – but they’re known invariably by other titles (actors, directors, etc.) – and a few sports workers – but they’re known as athletes – and quite a few finance workers – known as investment bankers, fund managers, and such – and quite a few…I guess I’d have to call them generic workers, since they can be in any industry…but they’re known as corporate executives – and a few legal service workers known as attorneys, and a few professional service workers known as consultants, and maybe a few health care workers known as doctors and surgeons, and so on.

Which brings me to my second, related point, which is that we don’t normally identify an occupation by the industry to which it belongs. The exceptions are sort of residual categories: we do call some people “health care workers” if we can’t think of anything better to call them, but most people in health care occupations (nurses, for example) would probably find it insulting to have their occupation identified as “health care worker.”

According to Wikipedia, a sex worker is someone (anyone, apparently) who works in the “sex industry.” I have a feeling that many people who work in the “sex industry” would be insulted to be called “sex workers” (rather like nurses, if you call them “health care workers”). I mean, really, doesn’t everyone know that the phrase “sex worker” is a euphemism for “prostitute”? (I know, technically, that’s not the case, but in real life, other “sex workers” seem to use the phrase for themselves only when they’re trying to make a show of their solidarity with prostitutes.)

But here’s the real problem: What the hell is the “sex industry”? And more to the point, what kind of industry is it?

An information industry? (The adult video industry, as best I can tell, is part of NAICS 512110, “Video production,” an information industry.)
A personal service industry? (Officially, Miss Dupré was probably working in NAICS 812990, the “Social escort services” industry, a personal service industry. As to what she was actually doing, it seems to me that prostitution is clearly a service, and it’s about as personal as services get.)
A food service industry? (I know that doesn’t make much sense, but where do strip clubs fit in the NAICS? As best I can tell, they are part of NAICS 722410, “Night clubs, alcoholic beverage,” a food service industry.)
An entertainment industry? (It’s really tough to find a NAICS code that would actually apply here, but aren’t strippers entertainers? Of course strippers also give lap dances, which are really more of a personal service than a form of entertainment. In fact, in that respect I have to question whether strippers are really more like prostitutes than entertainers.)
An amusement and recreation industry? (That’s pretty much just a wild guess. But where the hell do brothels fall in the NAICS? There are legal brothels in Nevada, so I assume they must have a NAICS code.)

As far as I can tell, the whole concept of a “sex industry” makes a mockery of the way we normally classify industries. I don’t have a problem with changing the occupational title of prostitutes to something that has less of a stigmatizing history. But “sex worker” just doesn’t do it for me. I’m going to try “personal sexual service provider” (PSSP for short) and see if it catches on. Otherwise I’ll just call them hookers – a term which doesn’t seem to offend people even though its etymology is rather scurrilous.

What's going on?

2008-03-21T17:31:00.003-04:00

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

Capital Flight is Good

2008-03-17T19:15:00.003-04:00

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
(in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

Moral Hazard

2008-03-16T23:54:00.001-04:00

[Hypothetical future investor]: I own a major stake in an investment bank, and I’m getting concerned about their risk management. Should I bring this up at the shareholders’ meeting?

[Hypothetical friend]: I don’t see why. What’s the worst that can happen? The bank will go sour, the Fed will arrange a bailout, and you’ll only lose 95 percent of the money you invested, 96 tops. What’s the big deal?

[Hypothetical future investor]: You’re right. Isn’t the [Hypothetical future Fed chairman] put great?

TSLF: Is the government taking a risk?

2008-03-16T18:36:00.002-04:00

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

Now I like Eliot Spitzer

2008-03-15T11:06:00.001-04:00

Eliot Spitzer has always struck me as a pompous, self-righteous, arrogant, heavy-handed, politically motivated ass. I find the publicly disgraced hypocrite to be a much more sympathetic character. Pretty much the bad things about Spitzer were things I already knew. I didn’t know the specifics of his being a john and a philanderer, but neither did I imagine that he could possibly achieve for himself the high moral standard that he seemed to require of everyone else. The main difference now is that he’s been caught. And being caught tends to neutralize the things I didn’t like about him: his political career is over; his hand is weak; and he is no longer in a position to be pompous, self-righteous, and arrogant. He’s still an ass, I guess, but nobody’s perfect.

UPDATE: Now that I read about what Spitzer has done to reduce human trafficking, I like him even more. Not quite as cool as keeping abortion legal, perhaps, but surely it's worth at least a hand job.

This inflaiton report scares me.

2008-03-14T16:57:00.004-04:00

Quoting myself from the comments section of my last post:

...Japan had plenty of missed opportunities in the early to mid 90s to prevent the depression from getting out of hand. It was only when the inflation rate went to zero...that it really became intractable.

Speak of the devil, and he shall ~~arrive~~ appear. I'm pretty sure we'll get positive core inflation in March (and there's no question that we'll get positive headline inflation), but seeing zero even in one month (as in today's February CPI report), while commodity prices are rising at unprecedented rates, is pretty disturbing. Both the 12-month CPI inflation rate and the 3-month annualized rate are 2.3%, which is right in the middle of the normal range. This is disturbing because it seems to indicate that business don't even have enough pricing power to pass on part of the huge cost increases they are facing in energy and materials. What happens when commodity prices stop rising? I don't think I want to find out.

Rising Inflation Expectations: Bad News or Good News?

2008-03-09T19:29:00.006-04:00

Suppose that Greg Mankiw and others are correct in suggesting that inflation expectations have risen dramatically. Is this bad news or good news?

By way of full disclosure, I should note that it’s clearly good news for me, since I’m short nominal Treasury notes. If you follow the logic, that means it’s in my interest to convince other investors that conditions are more inflationary than I really think they are, so while the main point of my last post still stands, you should probably take the caveats (“There's little question that the expected inflation rate has risen...”) with a grain of salt. (Rising inflation expectations are clearly good news for me, but if this is what the good news looks like, I’d hate to see what happens to nominal yields when inflation expectations are falling!)

As to the “general interest,” however, the most obvious interpretation is that rising inflation expectations are bad news, because they mean that markets have lost confidence in the Fed’s willingness to keep inflation within its perceived target range. Or, as Greg puts it (quoting the Cleveland Fed’s Web server and adding a double entendre), “the system ‘has experienced an unexpected error.’” If the market loses confidence in the Fed’s inflation target, then, theoretically, the change in the expectations term in the Phillips curve causes it to shift upward, and we can anticipate both higher unemployment rates (in the short run) and higher inflation rates (in both the short run and the long run, unless confidence is eventually restored) than we would otherwise experience at any given level of aggregate demand.

Under that interpretation, the higher unemployment rates in the short run are clearly bad news. As for the higher inflation rates, I’m not so sure. A slightly different, but related, interpretation is that the market correctly perceives that the Fed has finally come to its senses and raised its inflation target from an unreasonably low level. Indeed, the current crisis, in which reasonable people are worried both about inflation becoming unhinged and about a potential deflationary collapse, is a good demonstration of why the target should be higher. It is kind of hard to believe that the Fed has come to its senses, though, since the rest of the world’s major central banks have been even further from their senses than the Fed.

Even if you think the Fed’s perceived* inflation target (between 1.75% and 2% on the personal consumption deflator, which is maybe about 2.25% to 2.5% on the CPI) is reasonable, you might think there are certain situations where the target should be raised. One of those situations might be a “safety trap” – where investors shun all but ultra-safe assets, even when the expected returns become much lower than those on risky assets. Arguably (though the argument becomes much weaker when you look at the stock market instead of the credit markets) the US is experiencing a safety trap now, and one solution is to take away the safety of the supposed safe asset by promising to inflate away the returns to be earned by government bondholders. Another situation where raising the target might be a good idea is when the uncertainty around the expected inflation rate increases, so that pursuing the original target would produce a significant risk of deflation. There might be a fairly strong case (as I suggest in the previous paragraph) that the US is in that situation right now. Obviously if you think that current circumstances call for an increase in the inflation target, then it is good news to learn that (in the judgment of the market) the target has actually increased.

But all these interpretations assume that the general shape of the distribution of inflation possibilities remains roughly the same. Moreover, casual talk of “expected inflation” suggests that we think the mean and the median of the distribution are roughly the same, since “expected inflation” could refer to either one. But perhaps what has happened is that the mean of the distribution has risen but the median has not. I would interpret the Fed’s target more as a median than as a mean. I would certainly hope that it isn’t the mean, and that the Fed would be more willing to tolerate inflation rates 3% above its target (high by recent standards but far from disastrous) than rates 3% below its target (deflation, which could be disastrous). Under this interpretation, the market still has confidence in the Fed’s target as a median, but the market is reassured that extremely low inflation rates will not be tolerated, so that the distribution has become more skewed to the right, and the mean has risen. In that case, the increase in mean (but not median) inflation expectations is good news.

[UPDATE: Paul Krugman, using what seems to be another species of the "in this situation, the inflation target should be raised" argument, makes the case that high inflation expectations are good news.]

*The Fed has actually announced a 3-year-ahead forecast, which can perhaps be reasonably interpreted as a target.

Inflation Expectations

2008-03-09T12:16:00.003-04:00

This chart is showing up in too many places. The latest, to which I link, is Greg Mankiw's blog.

The implication is that the expected CPI inflation rate over the next ten years has risen from its typical value of around 2.5% to around 3.4% recently. There's little question that the expected inflation rate has risen over the past couple of months, with commodity prices rallying like never before (literally), and that is certainly an issue that the Fed has to be concerned about, but do we really believe that the expected inflation rate has risen quite so dramatically?

I don't. If you look at the raw breakeven inflation rate from the 10-year tips-to-nominals spread, it has only risen by about 20 basis points in the past couple of months, and it still hasn't taken out the highs that it made in 2005 and 2006. We can reasonably surmise that this understates the increase in expected inflation, since we also know that liquidity has gone to a premium over the past 6 months and that TIPS are less liquid than nominal Treasury notes. We can't quite be sure, though, because inflation uncertainty has also increased, so the increased risk premium for inflation uncertainty (which applies to nominal Treasuries) may be offsetting the increased liquidity premium (which applies to TIPS).

The 3.4 percent figure comes from a very specific way of estimating the liquidity premium. IIRC the Cleveland Fed does a regression on the spread between on-the-run (recently auctioned and therefore highly liquid) and off-the-run (slightly less liquid) Treasury notes. Recently that spread has increased dramatically, so the methodology is adding a large liquidity premium onto the expected inflation rate. But how large, exactly, should it be? Given that liquidity conditions are outside the range of the data prior to August 2007, and given that I think there are omitted variables (specifically, a time trend over the period during which TIPS were becoming more available and gaining more market acceptance, as well as a reverse time trend at the very beginning, when TIPS were new and exciting and therefore didn't need to offer high yields) in the specification, and given that I'm not sure that the on-the-run-to-off-the-run spread is the best measure of the liquidity premium anyhow, and given that there are issues about the inflation risk premium, I'm not at all comfortable accepting the Cleveland Fed's estimate.

Tax That Guy Behind the Tree

2008-02-22T17:16:00.003-05:00

Megan McArdle is right (here and here), and Henry Farrell and Mark Kleiman are -- perhaps not exactly wrong, but as far as I can tell, they are either misunderstanding what she says or quibbling on minor points of semantics while apparently believing themselves to have a substantive point. The question is, "Do people want their own taxes raised?" My answer comes more from introspection than from logic or economics. Perhaps Henry Farrell and Mark Kleiman want their taxes raised, but I certainly don't want mine raised. However, I am willing to have my taxes raised in exchange for certain things that I do prefer -- in particular, I'm willing to have my taxes raised in exchange for an increase in everyone else's taxes.

I want to make it quite clear that I will oppose any law that tries to raise my taxes by $300 -- unless that law also contains provisions that I support and that are worth $300 to me. Would a provision requiring my compatriots to kick in a total of $6,000,000,000 to the National Science Foundation be sufficient to gain my support for the package? Hell, yes! I would support the package because the provision that I like (a $6,000,000,000 increase in taxes from everyone else, to finance the NSF) far outweighs the provision that I don't like (a $300 increase in my own taxes). That doesn't mean I like paying $300 more in taxes. When I refuse to make an autonomous contribution to support NSF-like research, I am indeed revealing my preference for not paying more taxes. (And by the way, if someone proposes to exempt, say, people who were, as of February 2008, blogging using a vowelless pseudonym, from a new tax, I will support the amendment, because I really would prefer not to pay more taxes.)

It seems to me that much of the popularity of the anti-tax movement that began with Reagan-Kemp-Roth (or did it begin with Kennedy-Johnson?) was based on an appeal to people's genuine preference for lowering their own taxes, combined with a sort of mental cover-up of the implications of taxing other people. Basically, get people to think about the $300 question and ignore the $6,000,000,000 question. On the pro-tax side, it is precisely the failure to acknowledge that people don't want to pay higher taxes that made it difficult to counter the appeal of the anti-taxers. The pro-taxers insistence on philosophical mumbo-jumbo about collective action and such covered up the fact that they had a very strong common-sense case that they were somehow unwilling to press.

There is a valid concern that revenue doesn't quite rise linearly with tax rates and that high taxes can produce certain economic inefficiencies, but to me the basic math has always looked very good for taxes (in a large country like the US): even if the money is spent very inefficiently and not on my own priorities, $6,000,000,000 is a hell of a lot. The government would really have to make an incredibly huge mess of its spending in order for that not to be worth $300 to a reasonable person. (But again, if you could get it for free, that would be even better.)

St. Augustine

2008-02-18T20:59:00.005-05:00

I guess I was a little early with the Augustine reference back in August 2006, and maybe I should have translated it into English, but it looks like it's finally catching on.

Not a Bubble

2008-02-15T12:27:00.005-05:00

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, ~~Jane Galt~~ Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?

As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:

Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?

Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

Marginal Taxes on the Rich

2008-02-12T08:56:00.000-05:00

In response to the opening sentence of my last post, Greg Mankiw asks:

Have you ever turned down a money-making opportunity that you would have accepted if it paid twice as much?

I'll outsource the first part of the answer to "a student of economics," who comments on Greg's post via the comments section of my last post:

Greg asks the wrong question in an effort to get the answer he seeks.

The correct question should be, "would you turn down that opportunity if ALL your other money making opportunities also pay twice as much?"

It's not clear that I would do anything different if all my options improved by the same amount. There are only so many hours in day. In fact, perhaps I would actually work less and play more if I were twice as rich (assuming, of course, all gov't services magically continued without cost).

I do recall once having two job offers at comparable pay, and I'm sure that, if the one I rejected had paid twice as much, I would have taken that one instead. But it's pretty obvious that has nothing to do with taxation; it has to with what other opportunities are available. If both jobs had paid twice as much, I would have made the same choice that I did.

Part-time opportunities are a separate issue. I don't have a clear memory on this point, but it's quite possible that I've turned down consulting work that I would have accepted if it paid twice as much (though again, if all opportunities paid twice as much, I'm not sure how the income and substitution effects would sort out). In my case, though, the example (if there is one) would make my second point: that the incentive effects of higher marginal tax rates are not all bad. If I did turn down an assignment, it would be a job in support of one side or the other in a legal case or an interest arbitration. Given the near zero-sum nature of such proceedings, the negative externalities associated with my activities would have been quite high. In this case, the tax is Pigovian, and I'm confident that it's nowhere near high enough to equate the private rewards with the social value of such work. I've made a similar point before.

[UPDATE: Boy, my two sentences introducing a different topic are generating quite a large tangent. PGL at Angry Bear has this to say.]

UPDATE2: In a Update, Greg gets into the whole income and substitution effects business and argues that he is asking the right question because he is isolating the substitution effect, which is what matters for deadweight loss. But for most real-life examples, he's still wrong. It's fairly obvious in my example of having two job offers, but it's true in a lot of more subtle cases too, that one is not really making a substitution between labor and leisure; rather, one is substituting one labor opportunity for another. Usually, one doesn't have a firm offer for the alternative opportunity, but one has some reasonable idea of what opportunity may become available. If a job offer gets doubled, it becomes unrefusable simply because one will never get another offer so big.

It's true that, to the extent that one has marginal opportunities, as in my consulting example, there may be labor-leisure tradeoff, but even there to a large extent it may actually be an intertemporal tradeoff between different labor opportunities given a more-or-less fixed amount of total leisure over time. And I would reiterate my point that the taxes in these marginal cases are often Pigovian.

[UPDATE3: While we're on the topic, let me point back to this post in which I argue that progressive taxation (though not high overall taxation) can actually encourage entrepreneurial activity.]

Marginal Taxes on the Poor

2008-02-11T16:49:00.000-05:00

I've always been skeptical of the importance of the purported bad incentive effects of high marginal tax rates on high income earners. (I won't go into the details now, but I don't think the incentive effects are very strong -- at least at tax rates close to current tax rates -- and I don't think they're all bad.) For some time, though, I have been concerned about the effects of effective marginal taxes on low income earners. The problem is not the taxes they pay to the IRS (which they mostly don't, anyhow) but the effective taxes they pay to various subsidizers, price discriminators, and assistance providers in both the public and private sectors.

It has worried me that there might even be some point on the lower part of the income spectrum where the effective tax rate is greater than 100%. That is, you get more income; you no longer qualify for various assistance and subsidies; you slide up the "sliding scale" of various vendors and service providers who (officially or unofficially) give discounts for the financially challenged; you pay more in FICA and state and local taxes (even if you still don't pay Federal income taxes, which you might); and you end up worse off (even leaving aside any reduction in leisure) than when you had less income.

It turns out this was more than a theoretical possibility. Jeff Frankel (hat tip: Greg Mankiw) quotes Jeff Liebman with a story about a woman who "moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more." In her case it wasn't until after the (apparently irrevocable) decision that she discovered what a bad deal it was to make more money, so maybe the incentive effect per se wasn't a problem, but even someone like me, dubious as I am about "justice" as a moral concept, has a sense that this woman has been cheated and that what happened is "wrong." And eventually we have to assume that the incentive effects will matter: presumably Abraham Lincoln was right that you can't fool all of the people all of the time. Moreover, the incentive effects will matter even when the effective tax rate is "only" 80% or 90%. And it can only get worse when we begin to attempt universal health care on a national level.

In theory the solution is to consolidate all forms of public (and ideally, private) assistance into a single, fairly large grant, which can then be taxed away via the income tax at a reasonably slow rate for people who don't need it. That obviously isn't going to happen, and I don't have any other solutions to offer, but Jeff Frankel notes in passing that Jeff Liebman is an economic advisor to Barrack Obama. Given that Senator Obama is now the (not quite odds-on, as of this morning) favorite for the next presidency, I'm heartened that at least one of his economic advisors is thinking about the problem.

[UPDATE: My next post deals specifically with the issue raised in the first two sentences about high income earners. I guess it's hopeless, though, for me to get people to break that thread here and post comments on that more relevant entry.]

Has expected inflation really risen?

2008-02-03T22:49:00.000-05:00

Several economics and finance bloggers, such as Greg Mankiw and Felix Salmon, have been pointing to an apparent increase in long-term inflation expectations in the TIPS market that Greg Ip wrote about Thursday in the Wall Street Journal’s economics blog. It would all be very worrisome to me, except that when I look at the actual data, they don’t seem consistent with a reasonable story about rising inflation expectations.

Greg Ip gives a clear description of the indicator being used and why it is used:

The Fed has long looked at the difference between yields on nominal Treasurys and inflation-protected Treasurys (TIPS) for a sense of what investors expect inflation to be. The difference is the so-called “breakeven” rate — the inflation rate that equates returns on the two. The Fed also tries to strip out near-term inflation disturbances related to fluctuating energy and food prices by looking at what the market expects inflation to be starting five years from now and running for the next five years (i.e. from 2013 to 2108). This is the “five-year, five-year forward” breakeven rate.

I’m not sure exactly how the Fed, or Barclays Capital (the source for Greg Ip’s numbers), does the calculation, but I’m going to use what I think is a reasonable approximation. (I emphaize that it is an approximation, most likely not the calculation that the Fed does, but it should give a reasonable idea of what the general picture looks like, and it has the advantage that I can do it in my head just by looking at four easily available yields.) Here are the four relevant pieces of data for my approximation, taken from the Fed’s constant maturity data for two points in time (the day before Ben Bernanke’s Jan. 10 speech, and the day before Greg Ip’s Jan. 31 blog post):


                                Jan 9   Jan 30
5-year TIPS yield               0.94%    0.84%
5-year nominal treasury yield   3.10%    2.96%
10-year TIPS yield              1.56%    1.45%
10-year nominal treasury yield  3.82%    3.78%

Using brute force subtraction, these data imply the following approximate current breakeven inflation (BEI) rates:


                                Jan 9   Jan 30
Current 5-year BEI              2.16%    2.12%
Current 10-year BEI             2.26%    2.33%

The approximate “five-year, five-year forward” breakeven inflation rate is two times the 10-year BEI minus the 5-year BEI, as follows:


                                Jan 9   Jan 30
5-year, 5-year forward BEI      2.36%    2.54%

This change is similar to what Barclays found, so I trust that my approximation isn’t too far off. But it’s important to think about the current BEI rates and what they mean. The first thing you should notice is that the current 5-year BEI rates are below the 5-year forward BEI rates. That should make you a little suspicious already. Think about those “near-term inflation disturbances related to fluctuating energy and food prices” that the Fed is trying to filter out. There has been a huge run-up in commodity prices over the past 6 months, and over the past 5 years. Presumably this should have more effect on the inflation rate over the next 5 years than it will on the inflation rate over the subsequent 5 years. If these BEI rates were unbiased indicators of expected inflation, you would probably expect the current BEI to be higher than the 5-year forward BEI. Not that anyone really thinks they are unbiased indicators, but this observation underscores the point that risk premiums and liquidity premiums are more important than inflation expectations when comparing the behavior of different 5-year and 10-year securities.

Take a look specifically at the change between Jan. 9 and Jan. 30. The current 5-year BEI rate actually went down by 4 basis points. That observation, it seems to me, is rather hard to reconcile with a story that says investors were reacting to a dovish shift in Fed policy. Is there any way that a dovish shift could reduce the inflation rate over the next 5 years? Of course, the (inflationary) dovish shift might have been outweighed by (disinflationary) weak economic news. But in that case should we really be worrying about inflation expectations? In particular Greg Mankiw might need to reconsider his conclusion:

A rise in expected inflation is not consistent with the conventional wisdom that the economy is on the verge of a serious slump driven by inadequate aggregate demand. It is, however, consistent with the hypothesis that policymakers are overreacting to some bad economic news with excessive monetary and fiscal stimulus.

These data suggest to me that the chance of a serious slump has risen and that the monetary and fiscal stimulus has not caught up with that rising probability.

It’s still possible that the market’s perception of the Fed’s preferences has shifted in a dovish direction, and that would be one way to explain the behavior of the 10-year BEI. But in that case the market must also think the Fed will be less able to implement those dovish preferences in the immediate future.

An alternative explanation, which doesn’t require such a subtle analysis of the Fed’s preferences and abilities, is that inflation expectations in the near future have fallen (as the weak economic news would suggest) but that the liquidity premium on TIPS has also fallen (as have other liquidity preference indicators, such as the TED spread). If the same liquidity premium applies to 5-year and 10-year TIPS, then a drop in that liquidity premium, without any change in expected inflation rate, would result in higher current BEI rates at both the 5-year and 10-year horizon. That shift by itself would increase the 5-year, 5-year forward BEI rate. If, in addition to the drop in the liquidity premium, the current 5-year expected inflation rate fell but the 5-year forward expected inflation rate remained the same, that would result in exactly the pattern that we observe.

Monster Really Scares Me

2008-01-31T12:59:00.000-05:00

Just as I finished leaving a comment ~~(not yet accepted as of this writing)~~ on Paul Krugman's blog arguing that UI claims for January remain on balance in the "good news" column and that the personal consumption report is not bad news given what we already knew about retail sales, I learned that the Monster Employment Index (which measures online help wanted advertising) fell by a whopping 9 points (from 169 to 160) in January, after falling an even more whopping (but less surprising given the usual seasonal pattern) 14 points in December and a not so whopping (but still significant because the index has never dropped 3 months in a row before) 5 points in November. That makes a total drop of 28 points, or about 15%, over 3 months. Before December 2007, the index had never fallen by more than 3% over any 3 month period (since it began in October 2003). And note that the 15% drop comes as newspaper help wanted advertising is scraping against an all time low (since 1951, when the Conference Board's index began, but note that in December, it rose slightly from the all-time low in November). Over the past week or two, I had been starting to think that the odds were shifting against recession. Now I'm not so sure. In any case I think we can rule out the possibility that 2008 will turn out unexpectedly to be a year of normal growth. And I'm not so worried about import prices now; I think they'll be offset by a slowing of domestic inflation.

[UPDATE3: OK, now I found the post on Paul Krugman's blog where he said that someone else edits the comments. (I missed it the first time, because it was in an update that I didn't read.) And I notice that one of my comments on an earlier post has suddenly appeared. I guess they decided I was a respectable commenter after all.]

[UPDATE2: I removed the previous update, because ~~Paul Krugman (or~~ whoever approves comments for his blog) did approve my comment. (See link at the top.) I had assumed it wasn't going to be approved, because there were later comments comments already approved, but I guess these things don't necessarily go in order.]

[UPDATE: [removed] ]

Not Such a Weak Report

2008-01-30T10:09:00.000-05:00

Reading between the lines of the 4th quarter advance GDP report, I estimate that nonresidential final sales rose at about a 3% annual rate, which is about where I see the potential growth rate (and faster than the potential growth rate that the Fed sees). It thus appears that, in the 4th quarter, fundamental weakness was still localized in the residential construction industry, which will eventually get as small as it's going to get and stop bringing down GDP. While this report doesn't allow one to rule out the possibility that a recession began during the quarter, and it certainly doesn't foreclose the possibility of a recession beginning in 2008, it does, in my opinion, line up on balance as evidence against the likelihood of one.

When does monetary policy become ineffective?

2008-01-29T21:44:00.000-05:00

Mark Thoma* leaves a succinct comment on my previous post:

Where we differ is the point at which monetary policy loses its effectiveness - I think that happens way before i-rates hit zero.

It’s an interesting point, because it is a position that many economists (including Keynes himself) seem to have held over the years, but one which, as far as I can tell, has never made much sense.**

I should be more specific: It may make sense if you measure monetary policy in certain ways, but not if you measure monetary policy in the way that is reasonable given how today’s central banks set policy. One might be (but in my opinion shouldn’t be) inclined to measure monetary policy in terms of the volume of open market operations, or some similar measure. In that case, it is quite true that a volume of operations that was effective when the interest rate was 5% is no longer likely to be effective when the interest rate is 1%. And certainly the people responsible for conducting those operations do need to be concerned with the volume. But for us, as economists and such, who can and should view monetary policy with some degree of abstraction, it makes little sense to concern ourselves with the volume of such operations. The transaction costs associated with open market operations are tiny (and not proportional to volume anyhow); the market for Treasury bills to be purchased is vast and quite liquid; the absolute size of an open market operation is of little importance, except inasmuch as it affects other variables, such as interest rates. Moreover, the same argument applies to other “quantitative” measures of monetary policy, such as changes in bank reserves and changes in monetary aggregates.

Since today’s central banks (and the Fed in particular) generally define their policy stance in terms of an interest rate, the reasonable way to measure that stance is in terms of an interest rate. Now one might argue (but again, I don’t think one should) that a proportional change in the interest rate that was effective when the interest rate was high will no longer be effective when the interest rate is low. For example, if the interest rate is 8% and you lop off one fourth of it, making the interest rate 6%, that could be quite an effective policy move; but if the interest rate is 1% and you lop off one fourth of that, making the interest rate 0.75%, that is not likely to be very effective at all by comparison. But central banks don’t measure interest rates proportionally, they measure them in…usually 25 basis point increments. And a 75 basis point cut by the Fed, for example, is considered a big move whether the interest rate starts at 8% or at 3%. The sensible question, it seems to me, is whether the effect of a given cut – defined in basis points – will be diminished when interest rates are already low.

If anything, I would argue, the exact opposite should be true. Monetary policy works largely by affecting the discounted value of expected returns on capital assets. When the Fed cuts interest rates, all other things being equal, stocks are worth more, houses are worth more, factories are worth more, machines are worth more, contemplated investment projects are worth more, and so on. The more the value of an asset rises relative to the cost of producing it, the more it becomes profitable to employ people in producing that asset. And theory says this effect should get stronger the lower are interest rates to begin with.

To see the point, consider a world where the risk premium is not an issue and where the Fed sets long-term interest rates. And just to make it clear, consider the extreme case where “long-term” means perpetual. In that case, the value of an asset that produces a fixed stream of returns equals the value of the periodic return divided by the interest rate. Thus if the Fed were to reduce the interest rate from 5% to 4%, it would increase the value of such an asset by 20%. But if the Fed were to reduce the interest rate from 1% to 0%, it would increase the value of the asset by…well, you do the math. In the enterprise of producing an infinitely valuable asset, it is of course profitable to employ as many people as you possibly can, at whatever wage they might require. In the real world, where the Fed controls only short-term rates, and where there is a risk premium associated with most assets, the effect is not so dramatic, but the difference in the effectiveness of policy when interest rates are low vs. high should certainly be in the same direction.

If, therefore, we may define “monetary policy” as the manipulation of an interest rate by a central bank, then we should expect that monetary policy gains more effectiveness the closer the interest rate comes to zero. And indeed, technically, there is no point at which monetary policy, thus defined, “loses its effectiveness.” There is, of course, a point at which additional stimulative monetary policy becomes impossible to practice, namely, the precise point when the interest rate reaches zero.***

* As far as I know, this is the real Mark Thoma – by which I mean the one that writes Economist’s View – not someone else of the same name. As an aside, though, it occurs to me that there is no shared authentication between Blogger and Typepad, so one doesn’t really know such things for sure. If I wanted to, I could probably post comments on other people’s blogs while pretending to be Brad DeLong or Barry Ritholtz. Or one of them could pretend to be me – though it's hard to think of any reason why they might want to.

** Please do not fear, Gentle Reader, that I have entertained for even a brief moment the abominable heresy that St. Maynard may have held a view that was in any way unreasonable. (Indeed, at the very thought, I must ask you to excuse me while I make the sign of the Keynesian cross over my chest.) Rather, I merely posit that there are certain inherent difficulties in communication between the Truly Awakened and ordinary sentient beings such as we. Interpreting the words of our lord**** in accordance with the mere shadows that form our limited experience, it is we who may have fallen into error. I’m personally intrigued by an alternative exegesis preached to me once by radical political economist Stephen Marglin, who suggests that Keynes was referring not to a lack of effectiveness per se but to the political difficulties in implementing a very low interest rate policy in an economy where the rentier class is loath to give up the income it receives in the form of interest.

***Strictly speaking, this is not quite true. Interest rates on some Treasury bills went below zero in 1938. Apparently, there are some people out there who like their Treasury bills so much that they won’t give them up even if you offer a premium to redemption value.

****I trust that the lower case L keeps me safe from the charge of blasphemy. Surely the lord I have in mind was indeed ours. To whom, after all, could Keynes belong***** if not to the Keynesians.

*****Actually, I have nothing to say down here, but I got so fascinated with the idea of nested footnotes that I decided to push the concept one level further.

What is the purpose of a fiscal stimulus?

2008-01-28T08:20:00.000-05:00

In the course of thinking about my last post, I have come to a striking realization: the (primary) purpose of a fiscal stimulus is not, as commonly believed, to stimulate aggregate demand and thereby increase economic activity; the purpose is to prevent interest rates from going down.

If the purpose of a fiscal stimulus were to stimulate aggregate demand and thereby increase economic activity, then a fiscal stimulus would almost never be a good idea. Typically, when a fiscal stimulus is proposed, one will hear arguments against it from various economists, typically of the more conservative-leaning variety (as, for example, Andrew Samwick here). These arguments rest on the premise that the conventional reason for a fiscal stimulus is the true reason. They argue (in my opinion) convincingly that that reason is not a good one, and they conclude that a fiscal stimulus is a bad idea. Essentially, anything that fiscal policy can do, monetary policy can do better. And monetary policy will do it, because that’s the job of central bankers. And if you disagree with the central bank about whether we need a stimulus, it will do you no good to try to use fiscal policy unilaterally, because the central bank will act to offset the effect with higher interest rates.

There is one exception – one case where monetary policy (maybe) just doesn’t work: that is the case where the interest rate is zero. In that case, there is no opportunity for the central bank to stimulate the economy by reducing interest rates. And if the central bank tries to stimulate the economy just by increasing bank reserves, this may be ineffective, because banks, having obtained the funds at zero cost, will feel little pressure to make loans; they may simply hold all the extra reserves as free insurance against the prospect of unexpected cash needs. And moreover, their creditworthy customers may not be willing to borrow, even at extremely low interest rates, if they can’t think of anything good to do with the money. This may or may not have happened in Japan; it’s still controversial whether the Bank of Japan’s policy of “quantitative easing” had a major impact. Anyhow, it’s something to worry about.

But in the US, for example, the interest rate has not been zero since 1938. So this one exception does not apply. If you’re worried (like Paul Krugman) that the exception might apply at some point in the not too distant future, then your argument about today is not that the exception does apply, but that we need to take action to avoid the situation in which the exception would apply. In other words, you don’t want interest rates to go too far down. You want a fiscal stimulus to prevent interest rates from going down.

Alternatively, let’s say that you were calling for a fiscal stimulus (or perhaps a larger or better directed one than what we actually got) in 2001 and 2002 and that you had the foresight to see that a monetary stimulus would affect the economy by producing an excessive and ultimately destructive housing boom. If your foresight were that good, you would probably have seen also that the monetary stimulus would succeed in getting the economy going and getting the unemployment rate down. So you couldn’t advocate a fiscal stimulus for that purpose, which would already be served. Rather, you would advocate a fiscal stimulus to avoid an excessive housing boom – by preventing interest rates from going down.

Today it would be hard to argue that a monetary stimulus could spark another excessive housing boom. (It might, I think, spark some kind of a boom, but the boom will be more orderly and rational, given the “once bitten” status of the housing market, as well as the elimination of many of the prospects for creative financing.) But a monetary stimulus could have another bad effect – rising import prices due to sudden drop in the dollar. The way to avoid that effect is to keep US interest rates high enough to attract capital from abroad, which will prop up the dollar. And the way to do that is with fiscal policy – a policy to produce a demand for that capital, so that someone in the US will be willing to pay those interest rates. Again, the purpose of a fiscal stimulus is to prevent interest rates from going down.

[Update: pgl's response at Angry Bear makes me realize that my reference to "another bad effect – rising import prices" was misleading. Rising import prices are a good thing, in my opinion, in that they would help reduce the international imbalance (the large net inflow of goods to the US from Asia), but on balance, only a good thing if the prices rise slowly enough to avoid a dramatic deterioration of the output-inflation tradeoff (i.e. stagflation, or something like it). The argument for using a fiscal stimulus, and therefore having relatively higher interest rates, today is that higher rates would let the dollar fall gradually, thereby avoiding the shock from a sudden deterioration in the terms of trade. It would also avoid a sudden contractionary shock to the rest of the world's economy.]

What is a stimulus

2008-01-27T09:45:00.000-05:00

At the request of fellow commenter Robert D. Feinman, I’m expanding a comment from Economist’s View into a full blog post. Apropos of Paul Krugman’s column on the fiscal stimulus plan, Robert posted a comment asking:

What is "savings"? I understanding taking the check over to Walmart.

If I take the check and deposit it in my local bank what then? The bank loans out the money or buys notes from the Treasury (lending to the government). The money is then spent by the recipient. The difference is that in one case I determine how the money is "spent", in the other I delegate the spending to some one else. Why is one a stimulus and the other not?

In a later comment, I answered:

When you deposit the money in the bank, it doesn't actually get loaned out; it gets withdrawn by the Fed. That's an oversimplification, but it's roughly what happens. If you deposit money in the bank, it makes more money available in the banking system, which tends to push down the federal funds rate; but the Fed has a policy of controlling the federal funds rate, so it will act to offset your deposit by selling treasury bills (or, more precisely, probably, by buying fewer treasury bills than it otherwise would).

This raises the question of why we would need a fiscal stimulus in the first place, because if it wanted to, the Fed could just put more money in the banking system (causing the federal funds rate to fall), and there would be more loans and more purchases and we'd get the same stimulus. And the reason has to be something bad about low interest rates, but it's not clear exactly what. Maybe we're worried that low interest rates would weaken the dollar too much and cause an import price shock. Or maybe we're worried that interest rates will go down to zero (as they did in Japan), in which case banks might be unwilling to lend out the money that the Fed creates (since they wouldn't be taking any loss by just holding it, and the risks of lending might be too high).

I could add here that I think both of these considerations are things we should be worrying about right now.

Now that I think about it, though, the reason doesn’t have to be something bad about low interest rates; it could be, for example, the lag in effectiveness: one may imagine that tax rebates will be spent (if they are spent at all) more or less immediately, whereas if the money is in the banking system, it takes time to lend out, and it takes time for the borrowers to spend it.

When I actually say it, that argument doesn't sound very convincing, so I'll go back to "something bad about low interest rates," but I'll note that the "something bad" may also relate to policy lags. For example, if the "something bad" is an excessive housing boom, that also has a delayed economic stimulus effect, so that's a reason that the Fed can't do as big an initial stimulus with monetary policy as the government could do with fiscal policy.

The Pigou Club on YouTube

2008-01-26T18:49:00.000-05:00

This video was posted several months ago by Razela (i.r.l. Jamie Bernstein, but not apparently Leonard Bernstein's daughter of the same name) on YouTube, as a response to a video by Bill Richardson asking for ideas about energy.

She also has a blog with embedded videos, but I couldn't find this one on her blog.

The Race Card

2008-01-25T18:17:00.000-05:00

There’s a popular theory now (see for example Mark Kleiman here and here) that Clinton’s strategy is in South Carolina is essentially to lose and to blame the loss on near-universal black support for Obama, thus making Obama the black candidate – the one representing black people – and thereby making him unattractive to white voters in future primaries. I must say, the logic makes sense, but I just don’t understand the premise; it doesn’t ring true for me. Let me say that I am, as I avowed in an earlier post, an Obama supporter, certainly not an apologist for Clinton. And let me also say that I’m probably wrong: I’m no expert in political strategy, and when I say I don’t understand, I’m not trying to play Socrates; I’m genuinely curious. (Now that I think about it, if Socrates hadn’t actually been Socrates, he probably would have denied that he was trying to play Socrates too. But Socrates must have developed a reputation of being wise in philosophical matters, whereas I’m fairly safe from being considered wise in political matters.)

I just find it really hard to believe that the average Democrat – well, let’s say the average undecided Democrat – is enough of a racist to vote against a candidate just because that candidate is a black man with near-universal black support. I’m white, myself, and I don’t think I’m a racist, but I’m hardly the exemplar of politically correct non-racism, and I don’t have the sense that my attitude toward people of other races is much different from that of the average white Democrat. (I’m taking into account, of course, the way I imagine party alignments have changed, or in some cases even reversed, since 1965, but perhaps they haven’t changed as much as I thought?) Certainly, as much as the next white guy, I don’t want Willie Horton anywhere near me or my family. (For the record, though, I did vote for Dukakis.)

But I surely cannot imagine myself, assuming I were still on the fence, deciding to vote for Clinton because Obama looked too much like the representative of black people. If anything, for a perhaps slightly racist person like me who naturally doesn’t like to think of himself as being slightly racist, if I have other reasons to like a candidate, then the blacker he is, the better. After all, voting for Obama, the black candidate and the candidate of black people, shows that I’m not a racist, and gives the lie to all those bleedingheart liberals who might want to claim that I am. If Obama were just some candidate who technically happened to be black, there wouldn’t be nearly as much advantage in voting for him. And if I were the exemplar of politically correct non-racism, the advantage wouldn’t be there, because I would have no need to prove that I’m not a racist.

The comparison is made with Jesse Jackson, who was the black candidate when he ran and was not well-liked by white Democrats, particularly moderate white Democrats. But surely (am I being naïve here?) it was Jesse Jackson’s political opinions, not his race or his racial support, that turned off so many white voters. Clearly, Barrack Obama’s opinions are quite different from Jesse Jackson’s – if anything, to hear many of the liberal pundits tell it, the problem with Obama’s opinions is that they are too far from those of Jesse Jackson. Am I being naïve here? I knew some white people who supported Jesse Jackson, and I’m pretty sure it was because of his positions, not because of his race. And I knew some white people who opposed Jesse Jackson, and it sure seemed to me that they opposed him for the same reason that the others supported him.

The Deficit is Good

2008-01-22T03:46:00.000-05:00

I’ve said this before, but perhaps not in such bald terms. You can reasonably complain about the composition of expenditures or the composition of revenues under the fiscal policies of the last 7 years. But if you think the existence of a deficit – I mean a large deficit – has been a bad thing, you are just wrong. Back in 2006, I went into a lot of theoretical reasons why the deficit might be a good thing. But in the light of the housing crisis, it has become clear to me that there is a very simple reason why the deficit really has been a good thing: we have needed a fiscal stimulus this whole time (except maybe for, hmm, say February and March of 2006).

In fact we needed a much larger fiscal stimulus than what we had. Because we only had a relatively small fiscal stimulus, we had to rely on monetary policy to keep the economy going. That’s why we had a housing boom, and that’s why we are having a housing crash. Now I’ll grant you that policies such as better regulation could have reduced the severity of the boom and the subsequent crash. But that would have meant less aggregate demand arising from the housing sector (from the construction industry, mortgage equity withdrawal, etc.). And that would have meant a weaker economy. And as Paul Krugman suggests here, an economy with 63% of the population working was already nothing to write home about.

So…I’m not sure what to think about all the craziness that has been going on in the housing market. I’m not going to condone fraudulent mortgage originations or to say that it was a good thing that the bond rating agencies based their ratings on unreasonable assumptions. But all that was barely enough to keep our heads above water. I’m damn glad we’ve been running “large” budget deficits for the past 7 years. I’m glad Alan Greenspan made a ridiculous argument in 2001 about how terrible it would be to run out of Treasury bonds. It was the wrong argument, but the right conclusion.

I’m not glad about all the people that have died or been maimed in Iraq. Some things are clearly worse than a weak economy and a volatile housing market. But if the Iraq war hadn’t happened, I hope we would have found some other excuse to spend the money.

Obama and Abortion

2008-01-21T19:06:00.000-05:00

I’m a Democrat, and as of Saturday, I am no longer “leaning toward Obama”; I am an Obama supporter. (Unfortunately, I’ll be out of town on primary night.)

I’m also pro-abortion. Not pro-choice: I’m one of those people that Hilary Clinton hasn’t met, who is actually pro-abortion. (I don’t think I’ll try to explain this any further, because my opinions are probably extreme enough to offend even the feminists and civil libertarians with whom I find common cause.)

You might wonder, given that I’m pro-abortion, why I would support Obama. After all, as Clinton’s campaign informed New Hampshire voters,

Obama refuses to stand up for a woman's right to choose and repeatedly voted `present' on important legislation. As a State Senator, Obama voted `present' on seven abortion bills, including critical late term abortion procedure, two parental notification laws and three 'born alive' bills.

You may recall that Bill Clinton once “did not volunteer” certain relevant information with respect to an answer he gave in deposition. (Coincidentally, the information he did not volunteer also concerned something could be considered a form of birth control.) In this case, Hilary did not volunteer certain relevant information.

The information she (or her campaign) did not volunteer is that, in the Illinois legislature, voting “present” is equivalent to voting “no,” because a majority of “yes” votes are required for a measure to pass. Granted, “present” and “no” are not exactly the same, but the difference in this case is not a substantive one. The Clinton campaign said that it decided to put out the information in the quotation above because “as Senator Obama has said, ‘voting records matter.’” Of course, when Senator Obama said that voting records matter, his point was that, if you want to ascertain a candidate’s position on specific issues, you should watch what the candidate does rather than just listening to what he says. Apparently, the Clinton campaign’s response to Obama’s suggestion to look at substance rather than just rhetoric was to exploit a non-substantive aspect of Obama’s record in such a way as to blatantly mislead the reader as to its substance.

When politicians lie about something I don’t have strong opinions about (like with whom Bill Clinton did or did not have sexual relations) it doesn’t bother me that much. When they make blatantly misleading statements about something that I do have a strong opinion about, that pisses me off.

I wonder if it’s too late to get an absentee ballot.

Obama and the Progressives

2008-01-19T19:00:00.000-05:00

I'm just wondering if Senator Obama is pursuing a calculated strategy of saying things that get pundits on the left pissed at him. It probably won't help him win the nomination, but when and if he does win, it could help in the general election, and it could help even more in the process of governing. What better way, for example, to get the 8 or so Republican votes he will need to close debate on his health care plan in the Senate than by saying, "Paul Krugman hated this idea."

Note to Congressional Democrats

2008-01-17T11:01:00.000-05:00

(This means you, Senator~~s Edwards and~~ Clinton.)

If Congress passes a stimulus package full of new programs and all sorts of bells and whistles and tinsel and lights and stars and angels and golden balls with glitter on them, one that President Bush is almost certain to veto, and one that he, given his ideological preferences, could very easily justify vetoing, and indeed would have a hard time justifying ~~singing~~ signing, then it will be your fault, not his fault, if the recession turns out more severe than expected. I will hold you responsible. I suspect that voters will hold you responsible too.

If, on the other hand, Congress passes a simple if imperfect stimulus program that works on the revenue side -- say an across-the-board one-time tax rebate -- one that President Bush may not be happy with but will have a hard time justifying a veto, then if he does end up vetoing it, that will be his fault -- and all the more reason to elect a Democratic president. And if he signs it, well, I guess you'll just have to take the risk that the stimulus will actually work and that it will make things look a little better on election day than they otherwise would. A non-recessionary economy in 2008 -- seems to me that's a risk worth taking.

[Update: I should proofread these posts better. I don't think we're going to be seeing "Recession -- The Musical" any time soon.]

[Update2: ...and I should check my facts, too. Brock points out in the comments section that John Edwards is no longer in the Senate. Edwards does seem to have his own stimulus plan, though, and I hope he isn't thinking that it can wait until 2009 to be implemented. I guess I should include Senator Obama in my warning, too, but his suggestions have come closer to the sort of thing of which President Bush would have trouble justifying a veto, so I kind of felt he didn't need to be warned.]

The Economics and Politics of Trade

2007-12-28T11:45:00.000-05:00

Paul Krugman (hat tip: Mark Thoma, as usual) says:

…I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.

Greg Mankiw asks:

But what if those who are worried about trade are protectionists? Should we still respect them?

Until Paul Krugman gives his own answer, I think we can presume that the answer is yes. Respecting protectionists doesn’t mean we are willing to give in to their protectionist demands, but it does mean that we appreciate their concerns and presumably that we are interested in finding some way of accommodating those concerns, short of actual protectionist policies.

It helps, I think, to separate the positive question from the normative question. The positive question is, “Who is helped by trade, and who is harmed?” The normative question, in the abstract, is, “How much weight should we give to the interests of the various parties that are helped and harmed by trade?” Twenty years ago, there was an easy answer to the first question: “Nearly everyone is helped in the long run, and in the short run, only people in a few specific industries are harmed.” That made the answer to the normative question irrelevant. Unless one wanted to give a ridiculously high weight to the short run interests of industries that were hurt by trade, the conclusion was always that trade was good, and protectionism was bad. And anyone who disagreed could be written off as either representing a special interest or misunderstanding the positive economics, thus not deserving our respect.

The answer to the positive question is no longer easy, and Prof. Krugman suggests that the answer now may be something like this: “Rich Americans and poor foreigners are helped, while typical Americans are harmed.” I think most American economists, including both Greg Mankiw and Paul Krugman, will agree with my answer to the normative question: “Since poor foreigners are much, much, much, much poorer than typical Americans, any reasonable notion of distributive justice, utilitarian optimization, or human charity requires that we give more weight to the interests of poor foreigners.” But that answer is unattractively convenient for American economists, since, whether or not they are personally rich, they fall into the functionally defined category of “rich Americans” that benefit from trade. As Archie Bunker once said, “It’s always good to be generous when it don’t cost you nothing.”

The ultimate answer may be even more convenient for Paul Krugman, because it justifies his prior political preferences. He advocates addressing the concerns of protectionists by means of (broadly speaking) redistributionist policies that benefit typical Americans (trade losers) at the expense of rich Americans (trade winners). That answer is convenient, but nonetheless, provided that Prof. Krugman can substantiate his positive conclusions, pretty convincing (though perhaps I’m not one to judge, since I tend to agree with his prior political preferences anyhow). Whatever ones initial preferences regarding equity-efficiency tradeoffs, a recognition of the politics of trade should shift them a bit to the equity side. Or, more precisely, if the marginal efficiency gains (and equity gains at the global level) from trade are first order and you are already at your domestic optimum for the equity-efficiency tradeoff, then, with the introduction of the political constraint, the envelope theorem requires that you revise that domestic optimum.

Efficiency Wages?

2007-12-25T16:43:00.000-05:00

`It's only once a year, sir,' pleaded Bob, appearing from the Tank. `It shall not be repeated. I was making rather merry yesterday, sir.'

`Now, I'll tell you what, my friend,' said Scrooge,' I am not going to stand this sort of thing any longer. And therefore,' he continued, leaping from his stool, and giving Bob such a dig in the waistcoat that he staggered back into the Tank again;' and therefore I am about to raise your salary.'

Compulsory vs. Voluntary Voting

2007-12-23T19:11:00.000-05:00

Apropos of a recent post on Economist’s View, I was going to explain that voter turnout has nothing to do with the free rider problem and that basic economic logic suggests that smaller turnouts are better than larger ones, but Radek (a.k.a. YouNotSneaky!) beat me to it.

In the end, though, I think Radek is wrong, because we need some political logic to supplement the economic logic. To begin with, economic logic will indicate that voting is, for the individual, irrational, unless it is mandatory. Therefore (here’s the political part), under a voluntary voting regime, only irrational people will vote. Do we really want government by the irrational, for the irrational, and of the irrational?

This may sound like a bit of sophistry, but I really think it has some relevance to the real world. Generally, people with strong opinions – opinions that are strong enough to make people do something irrational – will vote (plus maybe a few people whose only strong opinion is about their own civic duty). Radek seems to think this is good, because the people with strong opinions will be better informed and will have thought more about the choices. I’m willing to concede that point in some contexts – in particular, when we’re operating, as it were, close to the center of the distribution of policy possibilities. But when we get into the tails of the distribution, things get weird. The people with really crazy opinions – that Aryans are a master race, that Muslims must conquer the world and establish a Caliphate with worldwide dominion, etc. – are the ones who can most be counted on to do irrational things, like voting, to further their cause. If you have 60% voter turnout, one group of crazies can take over by converting 31% of the population. That’s a difficult task, but history suggests it’s sometimes possible. If you have compulsory voting, the crazies have the significantly more difficult (but, again, history suggests, not impossible) task of converting 51% (well, OK, maybe 48%, since there won’t be perfect compliance) of the population. Under normal circumstances, compulsory voting isn’t going to have a dramatic effect on election outcomes, because, let’s face it, the candidates usually aren’t all that different in the grand scheme of things. But in the occasional weird case where the election really matters a whole hell of a lot, compulsory voting reduces the chance that dangerously insane people can take over the country. That might be worth all the extra shoe leather.

Mark Thoma has a different take. He does seem to think that 100% voter turnout would be a good thing, but he thinks that compulsory voting would be too much of an imposition on people’s liberty. But I have a suggestion: Start with a compulsory voting regime. Enforce it by using fines. Rename the fines, and call them taxes. In the case of people who do vote, rename the absence of a fine, and call it a tax with an offsetting transfer, actually not so much a transfer as a payment for the service of voting. So now we have a lump sum tax offset in most cases by a payment for a public service performed by the individual. The individual is free to pay the tax and not do the service, but presumably we set the payment high enough that only a few people will choose that option. Does Mark still object?

[Update: Thinking about my last paragraph, I realize it has an obvious implication about whose political interests are served by compulsory voting: the interests of those whose shadow price of time is low – which is to say, poorer people (and perhaps retirees). If your shadow price of time is high, the penalty for not voting will be outweighed by the value of your time, so the voting requirement won’t change your behavior. If your shadow price of time is low, the penalty will outweigh the value of your time, and you’ll definitely vote. So the voting requirement will shift election outcomes toward the side of the these low-shadow-price people – presumably people who can’t get well-paid employment on the margin, which is to say, typically, poor people. Voluntary voting, on the other hand, is, relatively speaking, good for the political interests of corporate lawyers and investment bankers.]

Good News about US Inflation

2007-12-15T18:55:00.000-05:00

Everybody’s getting so freaked out about the latest CPI report, and I don’t understand why. The supposed bad news – gargantuan increases in energy prices, substantial increases in food prices and in import prices – is last month’s news. You could have gotten most of this information by looking at commodity markets and foreign exchange markets a month (or two or three) ago, and, as Dean Baker points out, you could have gotten it with even more precision by looking at the latest report on import prices. I don’t see any real bad news in this report.

Over the past 3 months, energy prices have risen at a 33.8% annual rate. That’s dreadful, but it’s not news. Food prices have risen at a 4.3% annual rate. Kind of ugly, but also not news. In fact, the 0.3% November increase in food and beverage prices is kind of tame, considering. Transportation prices rose at a 14.4% annual rate over 3 months – that’s pretty much redundant information, since I already mentioned energy prices. Medical care prices rose at a 5.2% annual rate, but that’s not unusual.

The one thing that is both unusual and unexpected is the 0.8% monthly (4.1% annualized over 3 months) increase in apparel prices. But if you look at the 12-month change in apparel prices, it’s still down (-0.4%). While apparel prices may not fall as quickly in the future as they have in the recent past, I for one do not believe that we have suddenly entered a new regime during which apparel prices will be rising by 0.8% – or even 0.3% – every month. The fact that there was a blip in apparel prices in November – and not even enough to get the core inflation rate for November above 0.3% – is hardly a significant piece of bad news.

The last thing in the report that people may have found troubling is the 0.4% increase (3.6% for 3 months annualized) in housing prices (meaning mostly rent and owners’ equivalent rent). But are you really worried about housing costs – with huge inventories of unsold houses in most parts of the country? There is probably a temporary problem in the rental market, because people are getting foreclosed on and pushed into the rental market, and the properties they vacate are remaining vacant for a while. This problem may continue in coming months, but one can’t reasonably describe this as fundamental upward pressure on housing prices.

What’s left? The “other goods and services” category did rise by 0.3% in November – more than one would have hoped – but the other two categories, “education and communication” and “recreation,” each rose by only 0.1% – less than one would have expected. All in all, not a troubling report, unless you haven’t been paying attention to the news over the past few months.

If you’re obsessed with the aggregate inflation rate, you’re welcome to be horrified that “US inflation jumps to 4.3%” – as the headline on the weekend Financial Times declared, and you might also be unhappy with the 3-month core inflation rate (2.6% annualized). But when you look at the 12-month core rate of 2.3%, don’t be upset (like the Financial Times) that it is “higher than the Fed’s upper limit of 2 per cent.” That upper limit applies to the core personal consumption deflator, which is a different index and typically runs about 50 basis points (or anywhere from 0 to 100 basis points, depending on whom you ask) below the CPI. 2.3% core CPI inflation is not a problem.

Illegal Immigration

2007-12-09T00:00:00.000-05:00

Michael Kinsley (hat tip: Mark Thoma) is right, and Andrew Samwick is wrong. (Well, mostly wrong. He does make an important point about fairness to people who are trying to immigrate legally.)

Kinsley:

Another question: Why are you so upset about this particular form of lawbreaking? After all, there are lots of laws, not all of them enforced with vigor. The suspicion naturally arises that the illegality is not what bothers you. What bothers you is the immigration. There is an easy way to test this. Reducing illegal immigration is hard, but increasing legal immigration would be easy. If your view is that legal immigration is good and illegal immigration is bad, how about increasing legal immigration? How about doubling it? Any takers? So in the end, this is not really a debate about illegal immigration. This is a debate about immigration.

Samwick:

That's not a good test, unless Kinsley is arguing that a politician's desired amount of legal immigration should not depend (negatively) on the number of illegal immigrants who are already here. One does not have to argue that there are no differences between illegal and legal immigrants (for example, in their economic or fiscal impact) to assert that the key distinction of legality is relevant for public policy.

Let me try to clarify what I think Kinsley is arguing. Let’s suppose we ask a slightly different question: How many total immigrants, legal plus illegal, should we have in the US? I allow three different answers:

exactly as many as we have now,
more than we have now, or
fewer than we have now.

(I'm talking about immigration flows, not about a snapshot of the number of immigrants at a particular time.)

If you give the first answer, I’m inclined to doubt your sincerity. Undoubtedly there are some people who do think we have just the right number of immigrants, but it’s hard to imagine that there are many. It’s clear (to me anyhow, from reading blog comments on the subject) that there is a broad distribution of opinion about how many immigrants we should have. It seems implausible that the distribution would just happen to have a large atom located at exactly the status quo. You might support the status quo for reasons of general conservatism, but in that case, you’re not particularly against illegal immigration in general; you’re just against having more illegal immigration than we already have. If you are against illegal immigration in general, then you are against the status quo, and you’ll have to do better than claiming general conservatism.

If you give the second answer, then you are pro-immigration, and if you claim at the same time to be against illegal immigration, Michael Kinsley will presumably agree with you: “We all oppose breaking the law, or we ought to.” But if you are pro-immigration, you’ve got some explaining to do as to why illegal immigration should be more of an issue than “illegal drug use or illegal speeding.”

If you give the third answer, I submit that you are not just against illegal immigration; you are against immigration. (I mean against immigration at the margin; presumably that’s what it means to be against immigration, since hardly anyone would argue for zero immigration.)

It seems to me, though, that the real issue is not whether illegal immigration is good or bad, but what we should do about it. The question of what to do should depend not so much on how much immigration we want as on what the costs and benefits of various options are. If preventing illegal immigration were cheap, then presumably even pro-immigration people would support doing more about illegal immigration so that we could increase legal immigration. It isn’t cheap, and as someone who doesn’t consider immigration (at the margin) to be a bad thing, I see the general imperative for enforcing laws as the only major point in favor of strong enforcement. In my opinion, marijuana and exceeding the speed limit both cause more net harm than illegal immigration, and I don’t think we should devote any more resources to enforcing immigration laws than we do to enforcing marijuana laws or speed limits.

Pigovian Tacks

2007-12-07T14:39:00.001-05:00

Conventional estimates put the appropriate level for a carbon tax (to combat global warming) at the equivalent of between 10 cents and one dollar per galoon of gasoline. I've been driving on the highway in Connecticut today, and judging by the mix and behavior of vehicles after several years of rapidly rising gasoline prices, my intestinal econometrics tells me that $1 would not be anywhere near enough to have a significant impact: a dollar a gallon is basically saying we don't care much about global warming, or at least that we don't intend to address it primarily by reducing use of carbon-based fuels.

My modest (really!) proposal: a carbon tax equivalent to about $5 per gallon, to be phased in over, say, 10 years, with the first few increments to be fully rebated as lump sum transfers and later increments to be partially rebated and partially applied to. Medicare or other federal health care programs, with some provision for flexibility based on economic and budgetary conditions. Along with huge punitive tariffs on goods with Chinese content until the Chinese adopt similar policies.

Since most people seem to think even 10 cents per gallon is too much, my money would be on global warming. Unfortunately, because uncertainty is a big part of the problem, it's hard to know how to play it. If Case and Shiller come up with a futures contract for beachfront properties, though, it sounds like a good long-term short. But the contract would have to specify what happens when some fraction of the index ends up underwater (literally).

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Paradoxical Responses to Fedspeak

2007-11-30T10:36:00.000-05:00

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.

Falling Angels

2007-11-26T18:05:00.000-05:00

Tanta at Calculated Risk has an interesting (but very long) post about the nature of “subprime” lending. A central idea is that, before the recent lending boom, subprime borrowers were essentially just prime borrowers whose credit had gone sour – typically people with mortgages who needed to borrow more money to keep making the payments on their existing mortgages. The availability of “traditional” subprime loans often allowed them to avoid default on their original mortgages, which kept those mortgages in the “prime” category. The increased availability of subprime credit in recent years has thus helped keep down default rates on prime loans. But now that subprime credit has dried up, the prime loans are going to start looking worse than ever: potential defaulters that would, in the past, have been caught by the subprime safety net, will now become actual defaulters.

It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.

Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”

Indirect Effects of Export Demand

2007-11-22T16:11:00.001-05:00

Today let us be thankful for multiplier and accelerator effects. And in any case let us at least be aware of multiplier and accelerator effects. In particular, if you want to talk about the potential role of export demand in preventing a US recession, the story you tell should mostly be about multiplier and accelerator effects rather than direct effects. If you tell the story without mentioning multiplier and accelerator effects, the prospect looks pretty dismal, as in the following from an otherwise excellent commentary by Martin Wolf:

But exports are only some 12 per cent of GDP. They must grow by considerably more than 10 per cent a year, in real terms, if the contribution of net trade to the rate of growth is to be as much as 1 percentage point. It is likely to be much less.

“Much less” than 1 percentage point sounds like a pretty feeble force to set against the likely effects of a meltdown in housing and a collapse of credit, given the apparent importance of credit and of the “wealth effect” in maintaining consumer spending. But borrowing and wealth effects have never been the primary elements used to explain consumer spending: rather, they are factors that help explain deviations from the normal relationship between spending and income. That relationship has certainly not disappeared, and income is still the primary factor. The personal savings rate may be unusually low, but this doesn’t mean that consumption has started to follow a path independent of income. And when income rises, as it would from an increase in exports, we can expect consumption to rise also.

A little quick Keynesian arithmetic should make the point. Let’s suppose that the marginal propensity to consume is 0.7. That is, for every dollar in new income that households receive, they increase their consumption by 70 cents. (There may be other things happening simultaneously that reduce their consumption, so I don’t necessarily expect consumption to grow at 0.7 of the growth rate of income, but 0.7 seems plausible to me as an estimate of the direct effect of income. It’s certainly a lot more conservative than what we would get from the rule of thumb that takes the average propensity to consume as an estimate of the marginal propensity.) Then, as the familiar story goes, people in the export industry will spend 70% of their new income; then the people from whom they buy will spend 70% of their new income; and the people from whom those people buy will spend 70% of their new income; and so on. The sum of that infinite series is 1/(1-0.7) or 3.3. The total effect of that hypothesized 1 percentage point contribution from export growth becomes 3.3 percentage points. Suddenly I’m glad the actual export contribution is unlikely to be that high: I wouldn’t want the Fed to have to raise interest rates dramatically to prevent overheating.

I’ve ignored the effect of taxes, because I think 0.7 might be a reasonable guess at the marginal propensity to consume out of gross income, including the effect of taxes. US consumption shows a striking tendency to gravitate toward about 70% of GDP, though the mechanism might be something completely different. Anyhow, I’ll leave it to real economic modelers to sort out the details. The point is just that the multiplier effect is quantitatively important, and if one tries to discuss the effect of exports without it , one will miss more than half the picture.

But let’s not forget the accelerator effect either. After the last 5 or 25 years, the US is probably not geared up to be an export powerhouse. Recent export growth has nonetheless been impressive. But with few economists predicting a significant recovery in the dollar any time soon, the important question for businesses is not how much they can export immediately but how much they can export over, say, the next 10 years. The process of gearing up becomes a worthwhile proposition in itself. Thus it is to be expected that export demand should induce a significant increase in the category of nonresidential investment (although, as with consumption, it may be partly offset by other factors causing a decline in nonresidential investment). Then there is the interaction between the multiplier and accelerator effects: some investment will also be needed to support the new consumption that results from export demand, and so on.

It may have gone out of fashion to talk about multiplier and accelerator effects as such. But we still read statements like, “Gains in employment and income will support growth in consumer spending.” The gains in employment and income don’t come out of nowhere; there has to be some underlying source of demand. A scenario under which exports provide an underlying source of demand, and the indirect effects offset weakness in other areas, seems quite possible to me.

[UPDATE: I forgot to include the hat tip to Mark Thoma for that Martin Wolf commentary.]

Exchange Rate Expectations and Interest Rates

2007-11-21T12:44:00.000-05:00

Since I’m (unhappily) short US Treasury bonds at the moment, I should be glad so many people think that uncovered interest parity means US bond yields have to rise when investors lose confidence in the dollar. (See the comments section of this post from Brad DeLong.) But it just ain’t so! Unquestionably, there are reasons to expect interest rates (bond yields) to rise when the dollar weakens, but those reasons are more subtle, and have different economic implications, than a brute force application of uncovered interest parity would suggest.

The theory seems simple enough: if investors expect the value of the dollar to decline, they will require higher yields on their dollar-denominated bonds, to compensate for the lower exchange value of the dollars in which they expect to be paid. The problem is that people take the clause “investors expect the value of the dollar to decline” to refer to a condition independent of how investors respond to that condition. In most models, what actually happens when “investors expect the value of the dollar to decline” is that the value of the dollar immediately declines, and then investors no longer expect the value of the dollar to decline. And most of those models include uncovered interest parity.

Suppose international investors, holding US bonds, suddenly come to believe that the value of the dollar will decline. What do they do? First they sell their bonds, which does cause yields to rise temporarily, but… What do they do with the proceeds? Do they sit on those dollars and wait for yields to rise enough to entice them to buy bonds again? I would think not, if they expect the value of the dollar to decline: instead, investors convert those dollars into (for example) euros and sit on those euros (or invest them in European bonds) until some combination of interest rate and exchange rate movements entices them back to the US bond market. But they don’t have to wait very long, because, in the process of converting those dollars to euros, they have pushed down the value of the dollar sufficiently that it no longer needs to decline. Suddenly, with the dollar no longer expected to decline, US bond yields become very attractive. They become so attractive that investors bid yields back down to their old levels.

In the paragraph above, I’ve snuck in some elasticity assumptions to assure that the value of the dollar doesn’t rise again when investors convert their euros back into dollars to buy back the US bonds. In principle, interest rates and exchange rates should be determined simultaneously. But if we believe in the expectation-based world of uncovered interest parity, then we must also believe in a similar expectational parity between short-term and long-term interest rates. Short-term interest rates are set by monetary policy, and long-term interest rates depend on expectations of future short-term interest rates. So if we hold expected monetary policy constant, all interest rates will be constant. If long-term interest rates rose, investors would try to exchange all their short-term bonds for long-term bonds, but since monetary policy assures a perfectly elastic supply of short-term bonds, this process would not stop until long-term rates came back down. Under these circumstances, the only way the market can adjust to a loss of confidence in the dollar is by bidding down the exchange value of the dollar immediately, until it is no longer expected to fall.

Now, you might point out that expected monetary policy will likely respond to the declining value of the dollar by raising interest rates. That’s true, since the cheaper dollar makes US goods more attractive and thereby produces a stimulus that monetary policy needs to offset. But that is a consequence of the monetary policy reaction function and the goods market equilibrium, not a consequence of uncovered interest parity. And it doesn’t allow one to make the argument, “When investors lose confidence in the dollar, US interest rates will rise, causing the economy to weaken,” because the Fed is only expected to raise interest rates enough to prevent the economy from strengthening, not to weaken it relative to its original condition. There are other, more subtle arguments you could make about why interest rates might rise further (the inflationary impact of the J-curve, behavior of foreign central banks, etc.), and the economy might actually weaken, but we have already wandered far afield from uncovered interest parity. If you want to argue that a loss of confidence in the dollar will weaken the US economy, you’ve got a lot of explaining to do.