Tuesday, January 31, 2012

Diamondback Capital Agrees to Settle SEC Insider Trading Charges

The SEC announced that Diamondback Capital Management LLC has agreed to pay more than $9 million ($6 million of allegedly ill-gotten gains and $3 million civil penalty) to settle insider-trading charges brought by the Commission on Jan. 18. As part of the proposed settlement, the Stamford, Conn.-based hedge fund adviser also has submitted a statement of facts to the SEC and federal prosecutors, and entered into a non-prosecution agreement with the U.S. Attorney’s Office for the Southern District of New York. The proposed settlement would resolve charges of insider trading by Diamondback in shares of Dell Inc. and Nvidia Corp. in 2008 and 2009.

“We are pleased to have reached a prompt resolution of the charges against Diamondback,” said George S. Canellos, Director of the SEC’s New York Regional Office. “If approved by the court, we believe that the proposed settlement appropriately sanctions the misconduct while giving due credit to Diamondback for its substantial assistance in the government’s investigation and the pending actions against former employees and their co-defendants.”

Diamondback Capital Agrees to Settle SEC Insider Trading Charges

Consumer financial protection, 1984

The Financial Times reports an amazing interview with Martin Wheatley, the "head of the UK's new consumer protection watchdog."
Investors cannot be counted on to make rational choices so regulators need to “step into their footprints” and limit or ban the sale of potentially harmful products,

“You have to assume that you don’t have rational consumers. Faced with complex decisions or too much information, they default ... They hide behind credit rating agencies or behind the promises that are given to them by the salesperson,” said Mr Wheatley..

The new approach rests on research in behavioural economics that shows investors often make decisions contrary to their own interests because of their aversion to losses or unwillingness to ditch a losing strategy. It represents a profound shift in regulatory stance.

Rather than simply ensuring that consumers are provided with complete and accurate information, the FCA will be monitoring firms to make sure that the right kinds of products get sold to the right kinds of people.

I can't wait to see the Nanny State plan to help day traders to ditch those losing stocks faster. 

Behavioral economics does not imply aristocratic paternalism. Behavioral economics, if you take it seriously, leads to a much more libertarian outlook.

Which kinds of institutions are likely to lead to behavioral biases: highly competitve, free institutions that must adapt or fail? Or a government bureacracy, pestered by rent-seeking lobbyists, free to indulge in the Grand Theory of the Day, able to move the lives of millions on a whim and by definition immune from competition?

Sure, the market will get it wrong. But behavioral economics, if you take it seriously,  predicts that the regulator (the regulatory committee) will get it far worse. For regulators, even those that went to the right schools, are just as human and "behavioral" as the rest of us, and they are placed in institutions that lack many protections against bad decisions.

More generally, the case for free markets never was that markets always get it right. The case has always been based on the centuries of experience that governments get it far more wrong. 

Serious behaviorists know this. Thaler and Sunstein's "Nudge" is pretty careful not to jump from "people make mistakes" to "a benevolent bureacracy must take care of the charming moronic pesantry." Alas, fans of 19th century aristocratic paternalism, who call themselves "liberals" today, make the jump with alacrity. They love to (mis-) cite behavioral economics as cover for their interventions. As, apparaently,  Mr. Wheatley and the UK "protection" scheme he will now lead.

If he were to take behavioralism seriously, the interview would reveal a deep reflection on how he was going to keep his new agency from displaying all those biases likely to lead to bad decisions.

For example, his new power to tell bank A that its products are "mis-sold" will quickly and predictably lead to bank B taking his employees out to lunch to explain how terrible bank A's products are and how it must be stopped. "Consumer protection" has quickly morphed into "protection from competitors" the world over, and the behavioral biases of regulators (salience, social networks, etc.) are part of the story. "Watchdogs" become lap-dogs.

Where are the behavioral Stigler and Buchanan? It seems high time for a thoroughgoing behavioral analysis of the functioning of government bureacracy, legislation, and regulation.

Here's some real "financial protection" advice: Look at the elephants in the room.

The first thing the average American should do is get out of a highly leveraged, very illiquid investment that poses huge idiosyncratic risk. That's called an "owner-occupied home." Rent, and put the money in the stock market.  Or buy a smaller home, that you can afford. Our government is still nudging us in exactly the wrong direction

The seond thing the average American should do is save a whole lot more. Our government is pushing more subsidies for student, homeowner, and business loans, and dramatically raising the already high taxes on saving and investment. When the American consumer tried to start saving a bit more in 2008, our Government responded with massive "stimulus" whose explicit purpose was to undo this bout of national thriftiness and get us to consume more, now.

Who's behavioral here?

Update: (response to some comments).

There is a huge difference between the justifications for regulation.  1) Protecting people from fraud. This is enforcing contracts and property rights, which is an obvious function of government. 2) Protecting people from definable and remediable market failures. That's more tenuous, but still a justifiable form of regulation. Though it's dangerous, see the capture exmaples, and often backfires. 3) "Protecting" people because the beuracracy just thinks it knows how to run people's lives better than they do. This used to be called aristocratic paternalism. Now it's defended by a misreading of behavioral economics. That's what the post is about. I hope that helps. I see it's an issue worth revisiting.

Monday, January 30, 2012

Consumer financial protection, 1840

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

It doesn't always work out that way.

Even a well-intentioned usury law has the unintended consequence that poorer, smaller, less well connected people find it harder to get credit.  And it benefits richer, well-connected incumbents, by keeping down the rates they pay, and by stifling upstarts' competition for their businesses. Toby and Effi present a powerful case that this is what happened in 19th century America.

I like this paper also for a deeper methodological reason. Cause and effect are devilishly hard to distinguish in economics. We have many fewer good instruments or "natural experiments" than we would like. Toby and Effi build a strong case for cause and effect with patient and exhaustive circumstantial evidence. I can't cover all that in a blog post, but it's good to look for it in the paper.

Here are just a few of the fun facts.
  • Tighter usury laws led to less credit. People didn't easily get around them.
  • Tighter usury laws led to slower growth. A one percentage point lower rate ceiling translates in to 4-6% less economic growth over the next decade. 
  • Usury laws only affect the growth of small firms. Big firms do fine. 
Unlike many analyses, Toby and Effi spend a lot of effort understanding why the right hand variable moves. Why do states put in usury laws?
  • Usury laws relax in financial crises, when all interest rates spke and even well-connected borrowers are starting to be affected. 
  • Usury laws are stronger in states where voting is restricted to wealthy people. It's also stronger in states with other restrictions on competition such as restricted incorporation laws
  • Usury laws are relaxed when there are more newspapers, and when those newspapers are more active an challenging politics and corruption. 
In sum, "Our evidence suggests that incumbents with political power prefer stringent usury laws because they impede competition from potential new entrants who are credit rationed."

Now let's think about our massive financial regulation and consumer financial "protection." Let's guess who will end up benefiting...

Bank of America Still Causing Problems for Merrill Brokers

Bank of America has always been a disaster in the brokerage business, with a long history of mistreatment of its brokers. That outrage became well known when it took over the failing Merrill Lynch in 2008. Bank of America forced brokers out of the firm, by reducing payouts, refusing to pay for business which had already been booked, and for generally not having a clue how to run a brokerage firm. Merrill Lynch was not much better, given the fact that it was virtually bankrupt by the fourth quarter of 2008.

The complete mismanagement of the firm, first by Merrill, compounded by Bank of America, forced brokers to leave the firm, and doing so at their own financial peril, leaving behind significant deferred compensation and outstanding promissory notes. Apparently, staying was even worse.

That trend continues, three years later. On Wall Street is reporting that UBS is hiring teams of Merrill Lynch brokers. In an article "UBS Hires Raft of Veteran Merrill Brokers" Ashley Lau reports that UBS had placed a premium on brokers from Merrill, Bank of America's brokerage unit, by increasing up-front bonuses offered to those who signed before the end of 2011. That move came at the same time that Merrill brokers were about to receive the last of two big payouts on previous incentive plans.

The article continues to say that industry analysts said in early January that they expect to see more defections from Merrill's "Thundering Herd" of brokers, many already frustrated with changes since Bank of America purchased the firm three years ago, after the award payments are made in late January and early February.

We have been representing brokers in transition, contract and promissory note matters for over two decades, and are presently representing former Bank of America and Merrill Lynch brokers with their transition and promissory note issues. We have set up a dedicated email address for inquires from brokers who need assistance with their employment issues with Merrill Lynch, or any other wirehouse - brokers@seclaw.com


Friday, January 27, 2012

SEC Obtains Emergency Relief Against St. Louis-Based Private Investment Funds after Charging Them and Their Principal with Fraud

The SEC has obtained an emergency court order to freeze the assets of St. Louis-based private investment funds and management firms after suing them and their principal for a scheme to defraud investors. It is alleged that the principal diverted more than $9 million of investors’ money to himself without their knowledge or consent. He recorded the transfers as ‘loans” in his companies’ books. He raised $88 million from investors who were told their funds would be invested in emerging financial services and technology companies.

“Morriss attempted to hide his illegal transfers of investor funds by calling them ‘loans’ when in reality he had no intention of paying back the money and instead went on a spending spree,” said Eric I. Bustillo, Director of the SEC’s Miami Regional Office. “It is fraud, pure and simple.”

SEC Obtains Emergency Relief Against St. Louis-Based Private Investment Funds after Charging Them and Their Principal with Fraud

SEC Charges Florida Bank Holding Company and CEO with Misleading Investors about Loan Risks During Financial Crisis

The SEC charged a holding company for one of Florida’s largest banks and its top executive with misleading investors about growing problems in one of its significant loan portfolios early in the financial crisis. It is alleged that BankAtlantic Bancorp and it's CEO made misleading statements in public filings and earnings calls so as to hide the deteriorating state of a large portion of the bank’s commercial residential real estate land acquisition and development portfolio in 2007. BankAtlantic and the CEO then committed accounting fraud when they schemed to minimize BankAtlantic’s losses on their books by improperly recording loans.

“BankAtlantic and Levan used accounting gimmicks to conceal from investors the losses in a critical loan portfolio," said Robert Khuzami, Director of the SEC's Division of Enforcement. "This is exactly the type of information that is important to investors, and corporate executives who fail to make that required disclosure will face severe consequences."

SEC Charges Florida Bank Holding Company and CEO with Misleading Investors about Loan Risks During Financial Crisis

Thursday, January 26, 2012

A brief parable of over-differencing

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

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

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

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

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

FINRA Fines Merrill Lynch $1 Million for Failure to Arbitrate Disputes With Employees

FINRA has fined Merrill Lynch, Pierce, Fenner & Smith $1 million for failing to arbitrate disputes with employees relating to retention bonuses. Registered representatives who participated in the bonus program had to sign a promissory note that prevented them from arbitrating disagreements relating to the note, forcing the registered representatives to resolve disputes in New York state courts.

After merging with Bank of America in January 2009, Merrill Lynch implemented a bonus program to retain certain high-producing registered representatives and purposely structured it to circumvent the requirement to institute arbitration proceedings with employees when it sought to collect unpaid amounts from any of the registered representatives who later left the firm. FINRA rules require that disputes between firms and associated persons be arbitrated if they arise out of the business activities of the firm or associated person.

In January 2009, Merrill Lynch paid $2.8 billion in retention bonuses structured as loans to over 5,000 registered representatives. Merrill Lynch structured the program to make it appear that the funds for the program came from MLIFI, a non-registered affiliate, rather than from the firm itself, allowing it to pursue recovery of amounts due in the name of MLIFI in expedited hearings in New York state courts to circumvent Merrill Lynch's requirement to arbitrate disputes with its associated persons. Later that year, after a number of registered representatives left the firm without repaying the amounts due under the loan, Merrill Lynch filed over 90 actions in New York state court to collect amounts due under the promissory notes, thus violating a FINRA rule that requires firms to arbitrate disputes with employees.

FINRA Fines Merrill Lynch $1 Million for Failure to Arbitrate Disputes With Employees

FINRA Fines Citigroup Global Markets $725,000 for Failure to Disclose Conflicts of Interest in Research Reports

FINRA has fined Citigroup Global Markets, Inc. $725,000 for failing to disclose certain conflicts of interest in its research reports (published from January 2007 through March 2010) and research analysts' public appearances. Due to technical deficiencies, the database Citigroup used to identify and create disclosures was inaccurate or incomplete. In concluding this settlement, the firm neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

FINRA Fines Citigroup Global Markets $725,000 for Failure to Disclose Conflicts of Interest in Research Reports

Wednesday, January 25, 2012

547 pages

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

Demographics and stock prices

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

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

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

These facts dovetail with research (my summary here, but lots of people have made this point) that high price/earnings ratios correspond to lower subsequent returns, and low price/earnings ratios correrpond to higher subsequent returns. One alternative story is that low prices come when people expect low growth in cashflows, and high prices come when people expect better future cashflows. That story does not turn out to be true on average. So the buying and selling pressure view is consistent with those facts.

I'm still not convinced, however, for a few reasons (all completely acknowledged by Zheng and Mark -- no fight here, we're just dissecting the evidence). First, empirically, movements in stock prices are about the equity premium, how much more you expect to earn on stocks rather than bonds, not the overall level of returns. Stock prices are about the willingness to bear risk, not about saving or dissaving. If it's all about saving and dissaving, we should see bond prices and yields (adjusted for expected inflation) move right along with stock prices and expected returns. To construct a demographic theory of stock prices and returns we have to argue not that people want to save more in middle age, but that they become less risk averse in middle age. Maybe, but it's a different story.

Second, markets are internationally linked. There may not be any American savers  to sell your stocks to when you retire (especially if the taxation of investment returns rises sharply). But there will still be a billion Chinese! 

Empirically, you can see there are about three data points, and Zheng and Mark acknowledge playing a bit with the demographic data. Lots of other things generate the same correlation with P/E ratios. In my research, I've been emphasizing the link to economic conditions that you can also see in the P/E plot -- good prices in good times, bad prices in times of recession or stagnation.

However, this is also a more important question than people think. Stocks earned about 8% real and about 6% or so more than bonds over the long histories of data we have, starting in either 1926 or post WWII. Many people bake in the idea that we will continue to get great returns like these in the future. Many pension funds discount there liabilities at these high rates of return.

Maybe, maybe not. There are lots of stories that the expected return on stocks for the next 20-30 years could be a lower. Wider participation via index funds and 401(k) -- wider risk sharing -- is one. Demographics, whether local or global, are another. The chance that we will enter a few decades of slow economic growth is another.

"Who will you sell your stocks to when you retire?" is an important question. With limited data, thinking through the various stories to see if they make sense is the only way to make much progress.

Texas-Based Accountant Pleads Guilty to Lying to SEC Investigators

The SEC announced that a Texas-based former audit partner at accounting and consulting firm BDO USA LLP has pled guilty to criminal charges for lying to SEC enforcement staff during investigative testimony. Last year the SEC issued subpoenas to BDO and the accountant who was responsible for auditing several hedge funds managed by an investment adviser that the SEC is investigating. The criminal information states that the audit is a central issue in the SEC inquiry, and investigators took testimony from the accountant to obtain information about his role in the audit process and assess his credibility. He was the subject of a 2005 NASD (now FINRA) proceeding alleging that he took $49,350 in funds from a former employer for his personal use.

The criminal information alleges that during questioning in September 2011, the Texas-based accountant falsely testified to SEC staff that he was not aware of a $49,350 payment made on his behalf to his former employer. In fact, hewas aware that his attorney had repaid the $49,350 to the former employer as reimbursement of the funds he had allegedly taken for his personal use. The payment was made at the accountant’s direction and with his funds.

Texas-Based Accountant Pleads Guilty to Lying to SEC Investigators

Monday, January 23, 2012

Romer on Regulation

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

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

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

Paul cites Myron Scholes' law, "Asymptotically, any finite tax code collects zero revenue," to suggest that simple clear rules will never work. He cites the FAA's regulation of flight safety and the Army's  integration as successful examples in which regulators, given wide latitude but rewarded on results achieved. And he cites the OSHA as an example of the hopelessness of a rules-based approach. For example,
The height of stair rails shall be as follows:
Stair rails installed after March 15, 1991, shall be not less than 36 inches (91.5 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Stair rails installed before March 15, 1991, shall be not less than 30 inches (76 cm) nor more than 34 inches (86 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Paul comments:
 It is tempting to ridicule regulations like these, [you bet! -JC] but it is more informative to adopt the default assumption that the people who wrote them are as smart and dedicated as the people who work at the FAA. From this it follows that differences in what the two types of government employees actually do must be traced back to structural differences in the meta-rules that specify how their rules are established and enforced. The employees at the FAA have responsibility for flight safety. They do not have to adhere to our usual notions of legalistic process and are not subject to judicial review. In  contrast, employees of OSHA have to follow a precise process specified by law to establish or enforce a regulation. The judicial checks built into the process mean that employees at OSHA do not have any real responsibility for worker safety. All they can do is follow the process.
I'm not totally convinced. In part, I'm a pilot, aircraft owner, and flight instructor, so I have a slightly different view of the FAA than the average air traveler. Yes, commercial jet travel is remarkably safe. But it's not at all obvious how much of this comes from the FAA regulation, especially at the margin, and how much from technical progress in aircraft and pilot training.

The surest way to ensure flight safety is to make sure nobody takes off in the first place. That often seems to be the FAA's attitude towards the light aircraft that I fly.

For in fact the social optimum balances flight safety against the economic and personal advantages of flying. For commercial aircraft, the airline companies and the flying public are loud enough to be heard. For light aircraft, we are not. No FAA employee was ever fired for the number of flights that didn't happen, the number of pilots who gave up flying, the technical innovations that didn't happen under his watch.

And the Federal Aviation Regulations, plus the FAA's love of paperwork, can make the OSHA stair railings look positively simple. In fact, there are rules, there is right of appeal, and by and large the FAA does not have the authority to come out to your airport and shut you down if it doesn't like what you're doing. (It can, and does, dig in to the paperwork to find inevitable flaws.)  And these are good things!
Some of the FAA's "safety" regulation has the opposite effect. For example, automobile engines are now more reliable than light aircraft engines. But they and their parts are not "certified," a long and expensive process. So we use what's certified. Airplane-to-airplane collision avoidance systems have been on the market for several years that cost $1000, yet the FAA's system ("ADS-B") which will be much more expensive is taking years to come out.

I'll say this for the FAA: it's all much worse in Europe. And the FAA is not  corrupt. Wide latitude to make decisions as you see fit, and to selectively enforce a forest of rules, is usually a surefire recipe for corruption.

Looking forward to financial regulation, it seems inevitable that regulators, given wide latitude, and  charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety. The Fed's proposals to implement Dodd-Frank (comments here) seem already very clear in that direction

Scholes' rule is fun too, but the corollary is that any society will arbitrarily expand the complexity of its regulation and the deviousness of lawyers and accountants to avoid it, until nobody actually does anything anymore and the society grinds to a halt.

So, it's a great and thought provoking read, and it's making me think a lot harder, though I'm not totally convinced.

Saturday, January 21, 2012

New Keynesian Stimulus

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

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

So I guess I’d urge all the people now engaging in contorted debates about what S=I does and does not imply to read Mike first, and see whether you have any point left. 
As it happens, I've spent a lot of time reading and teaching New Keynesian models.

I  wrote a paper about New Keynesian models, published in the Journal of Political Economy (appendix, html on JSTOR).  I haven't totally digested the NK stimulus literature --  In addition to Mike's paper, Christiano, Eichenbaum and Rebelo; Gauti Eggertsson; Leeper Traum and Walker; Cogan, Cwik, Taylor, and Wieland are on my reading list -- but I've gotten far enough to have some sharp questions worth passing on in a blog post.

Krugman continues,
That doesn’t mean that you have to use Mike’s model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment

One thing I know for sure: This is wrong. (It's an understandable mistake, and many people make it.) The New Keynesian models are radically different from Old-Keynesian ISLM models. They are not a magic wand that lets you silence Lucas and Sargent and go back to the good old days.

New-Keynesian models have multiple equilibria. The model's responses -- such as the response of output to government spending or to monetary policy shocks -- are not controlled by demand and  supply.  They occur by cajoling the economy to jump to a different one of many possible equilibria. If you're going to write an honest op-ed about New Keynesian models, you really have to say "government spending will make the economy jump from one equilibrium to another."  Good luck! 

New Keynesian models offer a fundamentally different mechanism from the IS-LM or standard stories that Krugman -- and Bernanke, and lots of sensible people who think about policy -- find "actually more useful."

For example, the common-sense story for inflation control via the Taylor rule is this:  Inflation rises 1%, the Fed raises rates 1.5% so real rates rise 0.5%, "demand" falls, and inflation subsides.  In a new-Keynesian model, by contrast, if inflation rises 1%, the Fed engineers a hyperinflation where inflation will rise more and more! Not liking this threat, the private sector jumps to an alternative equilibrium in which inflation doesn't rise in the first place. New Keynesian models try to attain "determinacy" -- choose one of many equilibria -- by supposing that the Fed deliberately introduces "instability" (eigenvalues greater than one in system dynamics). Good luck explaining that honestly!

In the context of the zero bound and multipliers, not even this mechanism can work, because the interest rate is stuck at zero. There are "multiple locally-bounded equilibria."  Some stimulus models select equilbria by supposing that for any but the chosen one, people expect that the Fed will l hyperinflate many years in the future once the zero bound is lifted. Hmmm.

These problems can be fixed, and my paper shows how. Alas, the fix completely changes the model dynamics and predictions for the economy's reaction to shocks. 

Or maybe not. I know the simple New Keynesian models suffer these problems. (That's what the JPE paper is about.)  Do they apply to the stimulus models? I don't know yet. I certainly have some sharp questions to ask, and I don't see anything in the models I've looked at with a hope of solving these problems.

Moreover, even taken at face value, the predictions of New Keynesian models are a lot different from Krugman's advertisement that more G gives more Y.

Every NK stimulus model that I have read is "Ricardian." Government spending has very large effects, even if it is financed by current taxes. Good luck writing an op-ed that says, "The government should grab a trillion of new taxes this year and spend it. We'll all be a trillion and a half better off by Christmas."  The popular appeal of stimulus comes from the idea that borrowed money doesn't transparently reduce demand as much as taxed money.  But that's the iron discipline of models -- you can't take one prediction without the other. If you don't believe in taxed stimulus, you can't use a Ricardian New Keynesian model to defend borrowed stimulus. (Or you have to construct one in which there is a big difference, which I have not found so far.)

More weird stuff, from Gauti Eggertsson's introduction
Cutting taxes on labor or capital is contractionary under the special circumstances the United States is experiencing today. Meanwhile, the effect of temporarily increasing government spending is large, much larger than under normal circumstances. Similarly, some other forms of tax cuts, such as a reduction in sales taxes and investment tax credits, as suggested, for example, by Feldstein (2002) in the context of Japan’s “Great Recession,” are extremely effective....

At positive interest rates, a labor tax cut is expansionary, as the literature has emphasized in the past. But at zero interest rates, it flips signs and tax cuts become contractionary. Similarly while capital tax cuts are almost irrelevant in the model at a positive interest rate (up to the second decimal point) they become strongly negative at zero. Meanwhile, the multiplier of government spending not only stays positive at zero interest rates but becomes almost five times larger.
Tax cuts are contractionary? The stimulus failed because the large tax cut component dragged output down? That's new, and I didn't hear Krugman complaining! Maybe it's right, but you can see we're a long long way from simple ISLM logic. Also, it's clear that these models make a sharp distinction between zero and nonzero rates, that stimulus advocates certainly do not make.

I also notice that "deflationary spirals" are a big part of the analysis. For example, in Christiano et al.,
But, in contrast to the textbook scenario, the zero-bound scenario studied in the modern literature involves a deflationary spiral which contributes to and accompanies the large fall in output.
OK, but we have near zero short-term government rates, a 3% positive rate of inflation and far from zero corporate and long term rates. Does the analysis apply?

Back to reading. I'll post again if I get more NK stimulus insights. It may take a while. I still think it's yesterday's news. Sovereign default seems more important for the future.

Thursday, January 19, 2012

Stimulus and Etiquette

The stimulus wars are heating up again.

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

Some response seems called for.


Let's be clear what the "fiscal stimulus" argument is and is not about.

It is not about the proposition that governments should run deficits in recessions. They should, for simple tax-smoothing, consumption-smoothing, and social-insurance reasons, just as governments should finance wars with debt. That doesn't justify all deficits -- one can still argue that our government used the recession to radically increase permanent spending. But disliking "stimulus" is not the same thing as calling for an annually balanced budget.

Nor is it about debt financing of "infrastructure" or other genuine investments. If the project is valuable, do it. And recessions, with low interest rates and available workers, are good times to do it. That doesn't justify all "infrastructure" roads and rails to nowhere, of course. A good test: If China offers to deliver an infrastructure project at half price, but no "jobs" will be "created," do you still want it? If you say "yes, even more" than it's infrastructure. If you say "no, we need to create jobs" then it's stimulus. 

The "stimulus" proposition is that additional spending -- whether needed or not -- raises output and general welfare.  Pay people $1 to dig ditches and fill them up again, and the whole economy gains $1.5. Yes, endorsed by Krugman because it "feels like a job" (his back must not hurt like mine does) and by DeLong: "anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all."  

The "targeted," "infrastructure," and the whole worthy apparatus to monitor the wisdom of  "stimulus" spending (see John Taylor) is, in the Keynesian model, beside the point, or at best a smokescreen to befuddle the ignorant masses. It would in fact be better if the money were stolen. Thieves have high marginal propensity to consume, and they can get that "spending" out fast in an economy with few "shovel-ready" projects.

Stimulus is a remarkable proposition, because  micro fallacies morph into macro wisdom. We all lambaste mayors who tax small businesses (or borrow against future taxes) to build showpiece "jobs" projects. This way lies Buffalo. Yet for the economy as a whole, stimulus says, it's true. The hurricane should have been bigger, so the government would have spent more money to rebuild. Many stimulus advocates point to WWII spending. Think about what that means: all those tanks, ships, and airplanes on the ocean floor were not a terrible economic sacrifice we paid to win a desperate war. Every ship the Germans sunk let the government buy another ship, and gain a ship and a half worth of GDP in the process!

Such paradoxes are sometimes true in macroeconomics and finance -- for example, we can individually sell stocks, but collectively we can only drive down prices. But you can see how hard the proposition is once you understand it and pull back the smokescreen-- and how delectable "stimulus" is for politicians who  love to build those "jobs" projects even when they are a net drain.

On silence

I've been off this issue for a while, mainly because fiscal stimulus is so clearly off anyone's policy or economic agenda. The US is not about to deliberately borrow another few trillion dollars a year and send it down whatever rathole is handy in the name of stimulus. The Administration won't even use the word "stimulus" anymore. Europe is even less likely to do it. Krugman, amazingly, thinks Greece should be spending more.

Everyone else sees our task as avoiding a global sovereign-debt crisis.The fascinating macro economic question is why our "short run" recession seems to be turning in to "long run" stagnation and slow growth. Lack of government spending is not high on most people's lists.

So, fiscal stimulus doesn't seem worth much blogging effort to me. It's just off the menu. We might as well debate a gold standard vs. bimetallism.

The state of affairs

Stimulus still an economically interesting proposition, and there is a great deal of uncertainty about whether, when, and how well it might work. There is a huge academic literature being produced right now, as typically happens after any event makes the news.

Here are the facts. Some economic models do predict a fiscal stimulus effect. Some don't. Some of those models have huge holes in them (the standard IS LM model, which even Krugman admits is "ad hoc").  Some don't. The rather mysterious "New Keynesian" stimulus models could use a lot of investigation (More in an upcoming post.)

Even if stimulus works, when and for how long? A lot of models give more stimulus when interest rates are stuck at zero. But many advocates, like Krugman and Delong, want more government spending even for times and for countries (Greece) with high interest rates. Surely too much spending eventually leads to debt crises or strangling taxation, but when? (Then, advocates usually want inflation and devaluation, but that has a limit as well.) 

The facts are far from decisive.  The right says: "The government spent like a drunken sailor and we still had an awful recession. Stimulus Failed" The left says "It would have been way worse without the stimulus."  History does not paint a clear picture either. GDP rose a lot along with Government spending at the beginning of WWII. GDP didn't fall like a stone at the end of WWII. Economists are producing hundreds of papers and volumes of studies for us to sort through, which I'll review in the future, but cause and effect will always be hard to tease out in economics.

So, there is a lot of uncertainty and a lot we don't know about how the macroeconomy works. That's what makes being an economist fun! There is a lot that well-read thoughtful economists can do to summarize and contribute to this debate.


What help do we get from Krugman to help us understand this debate, sort out the assumptions and the facts?
  • Here: "Lucas/Cochrane made simple, fail-an-undergrad-quiz-level, errors."
  • Here:  "The nonsense problem"  Cochrane and Luas  don't have a "defensible model." 
  • Here: "The great Lucas made a nonsense argument by any standard"
  • Here: "Oh, and the Cochrane-Fama thing ...there doesn’t seem to be a model behind it, just a misunderstanding of what accounting identities mean"
  • Here: Again, "no model".
  •  Say's Law.Say's Law,   Say's Law and "Economic Barbarism". I and Lucas are "propounding Say’s Law — the idea, refuted 75 years ago, that all income must be spent and hence that supply creates its own demand"
  • Here: "New Keynesians understand New Classical models, but New Classicals don’t"
This is all ridiculous, of course. No, I -- and certainly Bob Lucas and Gene Fama -- am not making the "Say's law" fallacy. We all understand the difference between identities, budget constraints, and equilibrium conditions. Should I just respond "Bastiat's fallacy" over and over again?

(The issue is how saving = investment is achieved, and what happens out of equilibrium. Keynesian models specify that "plans" depend on income, and do not have to add up via a budget constraint -- you can "plan" to consume save and pay taxes more than your income. Income then adjusts until saving equals investment. In "classical" models, "plans" are called "demands" and have to add up to income. Prices adjust to clear markets. In "new Keynesian" models, those prices are sticky.  I'm simplifying drastically here for public consumption, so Brad and Paul, spare us the outburst on what a moron I am or that I didn't mention x assumption.)

"No model" is even more ridiculous. What, there is no economic model in which fiscal stimulus falls below 1.5? Or we somehow "don't have" the models in our graduate reading lists, and in the footnotes to my blog posts? "Barro, Kydland and Prescott, King and Baxter, King,Plosser, and Rebelo, Uhlig,.Taylor, don't exist?... Maybe those models are wrong. Maybe they are logically coherent but don't fit the data. But to say they don't exist is just ridiculous!

Then there are the insults and slander.The most hilarious are the doctor-heal-thyself accusations:
And Krugman  is a piker in this department relative to Delong, for example calling me and others "a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash." And " so on.

There is a lot of uncertainty in macro, both theoretical and empirical. There is a huge outpouring of serious work. How does it help at all to say your side has perfect wisdom, enshrined in a roughly 1975 vintage ISLM model, and everyone who disagrees, including Lucas, Prescott, Fama, and so forth is stupid, lying, doesn't understand econ 1, thinks 2+2=5, or in the pay of wall street? A worthy analysis investigates how sensible people can come to both views, and then isolates which assumptions or facts they differ on. (Something I haven't done here for lack of space, but will return to later.)

What is wrong with these people?

I'm not the first to notice this emptiness of argument, and they're starting to be defensive. It's ok to slander and insult, because, as Krugman writes and Delong  Endorses " This is not a game, and it is also not a dinner party; you have to be clear and forceful to get heard at all." It's all necessary because  "Economic policy matters" .

What self-important hogwash! Life is a dinner party -- at least if your goal is the truth, and you have a bit of humility to understand our limits and still be searching for it. Didn't your mothers tell you that? "Because it matters" is precisely why it's important to acknowledge our limitations and search politely for the answers.

Note to the blogosphere: This is not how real economists discuss things. I've had great and productive  interactions with Austan Goolsbee, Mike Woodford, David and Christina Romer among many other serious economists who are favorable to stimulus. Nobody calls anyone else a moron. Normal people behave this way. They can do so even if communicating via the internet. 

The question is, what is wrong with the rest of us that we pay so much attention?

Well, I'm done for a while, but I will return to stimulus soon, trying to digest the outpouring of thoughtful academic work on both sides. I realize I didn't get much into the theory or facts about stimulus, but this is a reaction blog post not an encyclopedia, so that will have to wait for another day.

Wednesday, January 18, 2012

Romney's 15%

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

Romney pays little income tax because, hold on...Romney has little income. The guy doesn't work. He lives on his investments and campaigns for President. If I took a year off of teaching to go on a round-the-world gliding tour, I wouldn't have much income either, and would pay little income tax.

(We're all guessing here, of course -- maybe it's all crafty shelters. But who cares about Romney anyway; the issue at stake is whether the US should substantially raise rates on everyone else's interest, dividends, capital gains, or wealth itself, in addition to estate and property taxes.)

Yes, from an economic perspective, interest, dividends and capital gains are not "income." Romney should pay taxes, and at least at the same rate as everyone else. He should pay taxes on his consumption, not the returns on his investments. 

A central proposition in the economics of optimal taxation is that the tax rate on capital should be zero or close to it. Like anything else in economics, there is a huge literature of ifs ands and buts, yet the result seems fairly robust.  (Google "optimal taxation of capital." This is not a political statement, there are thousands of pages of equations behind it. There is a separate "optimal taxation" literature on "optimal redistribution," with some equally surprising results that I'll write about some other day.)

Intuitively, this is related to the theorem that you shouldn't tax intermediate goods, or have tariffs for moving goods around the country.  Romney's income was taxed once, when he made it. It's not efficient to tax it again, because he chose to save it rather than spend it immediately on an orgy of houses, private jets, and a big vacation for his extended family.

If you made money in dollars, paid taxes, then went to Canada and got $1.20 Canadian, it would make no sense to say "you made 20 cents of income, we'll tax it." It makes no more sense to pay taxes again on money that is moved over time. We decry that Americans don't save enough, the Chinese, the trade deficit and so on. Well, if you want people to save more, stop taxing it.

For this reason, the U.S. Tax code has been slowly reducing the taxation of rates of return. Capital gains and dividends are now taxed less than ordinary income. IRAs, 401(k), 526, and a welter of other devices allow people to save and invest without paying taxes on the rates of return. (It would be much simpler to just eliminate taxes on rates of return, but then the lawyers and accountants would have nothing to do.) Dividends are finally taxed at the same rate as capital gains. Estate taxes have been slowly and chaotically lowered.

Taxes on capital and wealth also are singularly unproductive of income, and very productive of tax shelters.

It's been a slow and painful process. And now, about to be undone, for no good economic reason.

Obviously, economists need to communicate better. Economists in general need to keep reminding everyone to look at tax rates, distortions and incentives first and foremost, not taxes. Opinion writiers like Paul Krugman's post on the subject don't do the world a favor by deliberately forgetting this basic principle when it is politically convenient.

SEC charges UBS With Overstating Prices

Yet another problem at UBS. What is going on over there? - SEC Charges UBS with Overstating Prices of Securities - some by 100%!

SEC charges UBS advisory arm with overstating prices of securities in three mutual funds - Securities Technology Monitor. - Financial Planning

Tuesday, January 17, 2012

Powell's secrets

Jim Powell wrote a nice Forbes article, "The Most Important Secret of a Prosperous Economy," filled with his usual brand of thoughtful historical detail. Two paragraphs caught my eye,
Consider, for example, what it’s like trying to start and operate a legal business in Singapore (atop the World Bank’s Doing Business 2012 report on 183 countries) compared with Chad (at the bottom of the list). In Singapore, starting a legal business involves only 3 procedures, whereas in Chad there are 11 procedures. The process takes 3 days in Singapore, 66 days in Chad. It takes 26 days to obtain a construction permit in Singapore, 154 days in Chad. The filing fees, taxes and other costs of starting a legal business are 0.7 percent of per capita average income in Singapore, a dramatic contrast with Chad where such costs amount to 208.5 percent of per capita average income.

In Singapore, an estimated 84 hours are required each year to maintain tax-related records and prepare tax returns, versus 732 hours in Chad. Total taxes consume 27.1 percent of corporate profits in Singapore, 65.4 percent of corporate profits in Chad. Importing a container of goods costs $439 in Singapore, $8,525 in Chad. Exporting a container of goods: $456 in Singapore, $5,902 in Chad. Resolving a bankruptcy takes 9.6 months in Singapore, 4 years in Chad. In Singapore, the recovery rate (cents on the dollar) from a bankruptcy is 91.3 percent, but the recovery rate is zero in Chad. Is anyone surprised that per capita GDP is much higher in Singapore ($50,714) – about 55 times higher – than Chad ($920).
(The World Bank Report itself is a hilarious example of boosterish, glass-is-5%-full NGO writing. You'd think the whole planet was on a steady march of virtuous free-market reforms. But thanks for the data!) 

As we know, this doesn't cover the half of it. In a country regulated to death like Chad, I can't imagine that each of those 11 procedures comes easily as soon as you fill out the paperwork. The dark side, which the World Bank can't talk about, is just how many bribes and connections you need to make all this work.

This little story bears on the "micro vs. macro" question for our current troubles. "Macro" explanations revolve around deficits, money supplies, and so on. "Micro" is... well, like Chad. Surely, Chad's problems will not be solved by stimulus.

In our policy debates, we focus far too much I think on the explicit tax rates and easily measured regulations. "Macro," deficits and interest rates, are easier still.  The dark side of micro stagnation is just too hard to measure. That doesn't mean it isn't there. Running a business in the US isn't that easy anymore either.

Monday, January 16, 2012

DeLong on Friedmans and Freedoms

Brad DeLong put up a post on Milton and Rose Friedman's Free to Choose so succinct, so outrageous, and so revealing, it merits breaking the "Don't respond to Brad" rule. Here it is, in its entirety:
There are, I think two important things you should note when you start reading Friedman and Director Friedman's "Free to Choose". The first is that it was a book that was written 30 years ago. The second is that the Friedmans believed that they were fighting against the tide of history. They thought--in 1980--that liberty and prosperity were in retreat worldwide, and had been in retreat for at least fifty years."

This strikes us--this strikes me at least--as profoundly odd. When you ask me what "freedom" means, I tend to go back to Franklin Delano Roosevelt's four freedoms:
  • Freedom of speech
  • Freedom of religion
  • Freedom from want
  • Freedom from fear
When I think of major impingements on freedom, I don't think of the things that the Friedmans point to in 1980 as evidence that freedom is in retreat. I see 1980 as coming at the end of the fastest and most complete 50-year expansion of freedom, democracy, and prosperity the world had ever seen.
When you ask me what "freedom" means, I tend to go back to "life, liberty and the pursuit of happiness." Yes, indeed, freedom of speech and religion, and also the freedom  peaceably to assemble, and to petition my Government for a redress of grievances. The freedom to be secure in my person, houses, papers, (hard drive) and effects, against unreasonable searches and seizures. Due process when the Government accuses me of something or wants to confiscate my property. The freedom to own property, transact it as I see fit; the right voluntary to exchange property and labor with another. The freedom to travel, live, and work anywhere in the world.

"Freedom" means not being told by force what to do. In a peaceful society with functioning police and courts, in which private disputes are subject to the rule of law, the first and most important freedom is from government interference.

(Roosevelt was, by contrast, talking about a war. My complaint is with DeLong, not in this case with Roosevelt. "Freedom from want and fear" mean something different in the Warsaw ghetto than if we're talking about the social security inflation-adjustment formula. Brad uses this quote in the context of the Friedmans and peacetime economic policy. So am I.) 

Freedom of religion and of speech are rights, of individuals against interference by their government. By putting "freedom from want"  after the first two basic rights of a democratic society, this quote elevates "freedom from want" to a similar right, against the Federal Government, and thus against your fellow citizens.

No. "Freedom from want" is the result of a prosperous, free society. The first Amendment does not grant  a right to a check from the Government. "Freedom from fear" also applies to the Schecter brothers' fear that the National Recovery Administration might shut down their business for selling chickens too cheaply.

(I can foresee the inevitable calumny: "You free-marketers are all heartless, you just don't care." No. We care more. We want a system that actually delivers freedom from want.)

Brad saved the best for last.  Read it again (my emphasis):
I see 1980 as coming at the end of the fastest and most complete 50-year expansion of freedom, democracy, and prosperity the world had ever seen.
"The end??!!"

Here are a few "freedom, democracy and prosperity" events Brad seems to have missed since 1980:
  • The Reagan and Thatcher revolutions, including deregulation, tax reform, victory over inflation and inauguration of a 20-year economic boom. 
  • A billion Chinese released from abject poverty. (Hint to China: read Capitalism and Freedom next.)
  • A billion Indians, also starting to join the modern world, having begun to overturn their Keynesian / English-socialist model. 
  • We won the cold war. East and West Germany reunited. Eastern Europe freed.
  • The number of democracies, for example as scored by Polity, doubled since 1980. Many in Latin America and Africa too.
1980 was indeed an end. It was an end to US and UK inflation -- the result of mindless "stimulus" -- and the end of widespread acceptance of simpleminded Keynesian economics. It was the end of a brief interlude of unquestioning belief in the power of the Federal Government to solve all problems. It was the end of stagnation in the US and UK.

1980 was an inflection point for the advance of freedom, not its end! Yes, some of the Friedmans' dark worries did not pan out. Why not? Because people read the book! The Friedmans were fighting against the "tide of history." And turned it back. 

"Complete??!!"  We have a long way to go, and we've been heading backwards in the last few years, on all indices of economic and political freedom. Our 30 years of liberalizations may indeed now be coming to an end. The economic and political ills of the 1970s seem to be returning.

I'll agree with Brad on one thing -- It's a great time to read the book.

Saturday, January 14, 2012

News flash: Bernanke not clairvoyant

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

The Times can barely conceal its "how stupid were they" glee.
The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. ...But the officials...gave little credence to the possibility that the faltering housing market would weigh on the broader economy,... Instead they continued to tell one another throughout 2006 that the greatest danger was inflation...
Justin Wolfers says the lack of foresight is "embarrassing," 
“It’s embarrassing for the Fed,” said Justin Wolfers, an economics professor at the University of Pennsylvania. “You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets.”
“It’s also embarrassing for economics,” he continued. “My strong guess is that if we had a transcript of any other economist, there would be at least as much fodder.”
(I hope for Justin's sake that his quotes were as usual mangled and taken out of context.)

The Journal piles on. Cassandras were ignored: "A handful of Fed officials warned of trouble brewing." The other "Fed officials were expecting a manageable slowdown in the housing sector, with little damage to the financial system or broader economy." And heavens, they even had "praise for outgoing Fed Chairman Alan Greenspan."

Well, that was fun. But what's the point, dear Times? We just need to put "smarter" people in charge and all will be well?

The real lesson is this: The smartest people in the room didn't -- couldn't -- see it coming. The smartest people in the room won't see the next one coming either.  

Nobody can systematically predict the financial future a lot better. If they could, they'd be rich enough to bail out the National Debt.

Sure, some people warned of this event.  But half of them won't see the next one. The other half have already predicted 5 more crises that never happened. The project "we'll just find someone a lot smarter or wiser than Ben Bernanke" is hopeless!

It's not embarrassing to my economics. The main prediction of market efficiency is precisely that nobody can systematically see market movements and bank runs ahead of time. Efficient markets are not clairvoyant markets. That prediction seems rather brilliantly confirmed!

This matters. We have doubled down on the idea that we can appoint All Powerful Regulators to  presciently spot "bubbles" and "imbalances" before private forecasters and the harsh judgment of financial markets do so, and then regulate away the risks. This strategy has already failed at least three times, after the crisis: The SEC didn't notice Bernie Madoff; the CFTC didn't stop Jon Corzine, and the entire European bank regulatory apparatus failed to notice that sovereign debt might be risky.

This story is embarrassing, yes. But it's most embarrassing for the Times and other believers in the idea of clairvoyant, all-powerful discretionary regulators. It's not at all embarrassing if you think Fed officials are as human as the rest of us -- and that safety comes from better rules of the game, not finding just the right soothsayer to run the show.

Friday, January 13, 2012

What zero bound?

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

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

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

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

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

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

The best story I've heard so far, suggested by one of the smart students in my MBA class, is this: It's a bet on Germany leaving the Euro. If Germany leaves the Euro, it is likely to redenominate its bonds and so pay off in new DM. The ECB is likely to leave reserves in Euros. So, if you want an asset that will pay off in new DM after Germany leaves the Euro, German government bonds are a good bet.

That story pierces the zero bound. There really is no limit to how low bond yields can go if you think bonds might be paid off in a better currency than the one you can stuff in your mattress. 

It sounds a little outlandish, and the chances that Germany leaves the Euro in 6 months seems pretty low to me. Still, it's a nice story. Does anyone have a better one? Remember, you can't answer why bonds look so good -- you have to explain why bonds are a better asset than reserves, for a German bank to hold!

Thursday, January 12, 2012

Hungarian Outrage

I stumbled across this lovely little post from Hungary, titled "This is why I don't give you a job"

It's full of classic unintended-consequence reminders for economists.  For example, protecting people by not letting employers fire them means that people don't get jobs in the first place.

It has some good reminders for the US as well.

Unemployment is still a huge problem. Policy after policy is advanced to do something about "jobs." Yet, like Hungary, our Government puts all sorts of barriers in to place that discourage employment.  Payroll tax, income tax, benefits regulation, workplace regulation, to say nothing of the tender ministrations of the nlrb, eeoc, osha, immigration and so on.   "Get out of the way" sounds simplistic, but there is a lot IN the way. I'd love to see a comparable, accurate post for the US. (Maybe I'll write it)

This thought also informs the "Macro vs. Micro" debate. Many macroeconomists, well exemplified by Bob Hall's AEA presidential address and subsequent work, are worried about the "zero bound" on interest rates. Because nominal interest rates can't fall (much--see German bonds) below zero, we can't have a real interest rate lower than the negative of the inflation rate, or less than about -3% right now. That is a potential "wedge," a distortion in the economy, and policies from fiscal stimulus (Christiano, Eichenbaum and Rebelo for example) to a time-varying tax on consumption (Correia, Nicolini, and Farhi for example) are proposed to deal with it.

But is this the first-order, most important "wedge" distorting the decision to hire more people? Is a -3% real rate really the Big Problem in our economy? Or are the manifest financial, legal, and regulatory barriers to hiring people a larger distortion in labor markets? I haven't jumped on the zero bound bandwagon, in part because my finance background leads me to look more at credit spreads than the level of short-term government rates, but also partly on a suspicion that the really big wedges lie elsewhere. As they surely do in Hungary.

(Hungary is a beautiful place by the way. I enjoyed three weeks in Szeged in 2010 while flying in the world gliding championships, getting to see the countryside a little closer-up than I had planned. My heart goes out to the wonderful people I met there.)

Wednesday, January 11, 2012

Illinois-Based Adviser Charged by SEC in Social Media Scam

The SEC alleges that an Illinois-based investment adviser offered more than $500 billion in fake securities through social media websites.

“Fraudsters are quick to adapt to new technologies to exploit them for unlawful purposes,” said Robert B. Kaplan, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “Social media is no exception, and today’s enforcement action reflects our determination to pursue fraudulent activity on new and evolving platforms.”

“More and more, investors are using social media to help them with investment decisions. While social media can provide many benefits for investors, it also makes an attractive target for fraudsters. The Investor Alert provides some useful tips to help investors look out for securities fraud online,” said Lori J. Schock, Director of the Office of Investor Education and Advocacy.

SEC Charges Illinois-Based Adviser in Social Media Scam

The World's Biggest Hedge Fund

The world's largest hedge fund paid $79.3 billion dollars to its main investor last year, as announced to the press and reported by the Wall Street Journal this morning.

It followed classic hedge-fund strategies. It's leveraged about 55 to 1, meaning that for every dollar of capital it borrows 55 dollars to fund 56 dollars of investments. Its borrowing is mainly overnight debt. It used that money to make aggressive bets in long-run government bonds, as well as strong speculative positions in mortgage-backed securities and direct distressed lending. Lately it's been putting bigger bets on loans to Europe and currency swaps. (Balance sheet here.)

The payout was actually conservative, as it reflected only the greater interest payments earned on its portfolio of assets and realized gains, not the substantial unrealized capital gains it made over the last year as long-term bond prices rose.

Who is this miraculous fund? Why our own Federal Reserve of course! 

Is this good or bad?

One argument for "good" was made famously by Milton Friedman. Commenting on central bank's interventions in currency markets, he pointed out that the central bank, like any trader, contributes to stability of asset prices if it makes money by trading. If you successfully buy low and sell high, then your actions raise prices in bad times and dampen them in good times. The usual practice of defending currencies and then giving in and devaluing them has the opposite effect.

By that measure, our Fed scores well so far. (I'm presuming here that price stability is desirable, which purists may quibble with, but let's not go there right now.)  On the other hand, we also know not to evaluate long-term portfolio performance with one good bet.

There is also no return without risk. Any trader who makes a superbly good return in one period is taking a risk of poor returns in the next. When (not if, when) long-term interest rates rise, the Fed will lose money on its portfolio of long-term bonds. If the economy gets worse, it will lose money on its credit risk portfolio. And so on.

Taking big portfolio risks is quite a change for the central bank. Traditionally, a central bank issues currency and reserves  and holds very short-term government or high-rated private debt. It earns a liquidity spread which it rebates to the Treasury. It does not take on substantial term or credit risk, and therefore it does not expose the Treasury to the possibility of losses.

(Some people think that central bank capital or portfolio losses don't matter. After all, it can always print money to pay its bills. That view is a fallacy. When the Fed needs to contract the money supply or raise interest, it needs assets to sell. Losses on its investment portfolio must eventually be made up by extra taxes. Benn Steil explains in more depth here and I'll come back to this issue if the comments section lights up.)

How much of a problem is the Fed's risk-taking, though?  In terms of overall debt and deficits, the Fed does not pose that much of a threat. Or, perhaps I should say, other things are worse. The Fed's balance sheet is "only" $3 trillion dollars. Even if it lost half of its assets, $1.5 trillion is one year's worth of Federal deficits,  10% of GDP, or 10% of the national debt. Losses on the Fed's portfolio are not going to bankrupt the country or send us to hyperinflation. The Treasury can sell bonds and give them to (sorry, "recapitalize") the Fed, and then raise taxes to pay off the bonds.  (That said, it would be nice to see a "stress test" on the central bank. Doctor, heal thyself.)

The real danger, then, is political, not financial. Imagine the fallout if the Treasury has to bail out the Fed to the tune of a few hundred billion dollars. The Fed would certainly lose a lot of independence.

Current thinking about monetary policy values the independence of the central bank.  An independent central bank is a way for the government to precommit ex-ante that it won't try to goose the money supply ex-post around elections. 

But the price of independence is limited authority. You cannot, in a democracy, have appointed officials with very long tenure writing checks to voters, allocating credit to specific industries, choosing winners and losers, or signing up the Treasury for trillions of dollars of tax liability.  The Fed cannot drop money from helicopters as Milton Friedman once recommended; that's called a transfer payment. The Fed can, in theory, only buy and sell safe securities of equal value. As dysfunctional as Congress and Administration may be, taxing and spending are their job, as they face the voters.

Of course, Federal Reserve actions have always had fiscal consequences. For much of history, the main role of central banks was to lower the interest rate on government debt, by making that debt more liquid.  And its "independence" has always been a relative thing as well. So as in many things, there is a sliding scale. But our Fed has certainly moved dramatically in the direction of actions with important, direct fiscal consequences. It must bear some cost of less independence as a result. We'll see what that is.

But potential portfolio losses strike me as a tip of the iceberg of actions that threaten the Fed's independence. The Fed participated in bailouts of specific companies and industries. It allocated credit to specific markets. In its expanded role as regulator it will be telling more and more banks how to run their businesses. It is now speaking more and more loudly about tax and spending policy, such as advocating mortgage bailouts. Its is setting "financial policy" more than "monetary policy."
The Fed is not likely to remain as independent in this expanded and very political role.

One thing is clear -- our monetary policy and central banking institutions are evolving fast.

Monday, January 9, 2012

Goolsbee on budgets

My colleague Austan Goolsbee wrote a thoughtful Wall Street Journal Op-Ed last week titled "Washington isn't spending too much." I agree with more of it than you might think -- though with a few important asterisks.

The last paragraph caught my eye:

"The election should lay out each candidate's fiscal grand bargain and growth strategy. Let us compare them. They matter. This could make up the heart of a historically important presidential contest."

Yes indeed. But I don't think Austan's partisan tone is justified -- he was criticizing Republicans in Iowa. This could have been written by the Ron Paul campaign, followed quickly by acid comments that "tax the rich" is not a "fiscal grand bargain" with any hope of closing the long-run budget gap, and neither it nor more Solyndras are a "growth strategy" as economists understand long-run growth.

Here's an optimistic interpretation: Austan advises the Obama campaign. Perhaps he's dropping a hint that the campaign will unveil that grand bargain -- with a plan to get it through Congress -- and a serious growth strategy. If they do, they'll win the election and save the economy.

Austan also gets it absolutely right that
"The true fiscal challenge is 10, 20 and 30 years down the road. An aging population and rising health-care costs mean that spending will rise again and imply a larger size of government than we have ever had..."
My only quibble is that this challenge may not be so far "down the road" as Austan supposes. Bond markets panic when they see danger ahead. (Lots more here.)

The more controversial question is Austan's view that our current enormous deficits are just due to the recession, not unusually profilgate spending, and the budget will quickly recover once the economy recovers.

John Taylor took Austan to task on that question, pointing out that the Administration's February budget proposal showed no reversion to normal spending even as the economy recovers.  I think John's being a little harsh here.  After all, the budget was quickly ignored. 

But you're here for economics, not personalities. How much of our deficit is just "normal" response to an unusually deep recession? Will the deficits fade away quickly as the economy recovers? Is spending really not a problem?

Deficits do and should rise in recessions. Tax revenues fall in recessions. A family that runs in to hard times -- business doing badly, losing a job, etc. -- should dip in to savings, or even borrow to keep expenditures relatively constant, and pay that back when good times return. Governments are the same. This is uncontroversial "consumption smoothing" and has nothing to do with attempts at "stimulus." You may -- as I do -- think that government is spending grossly too much overall, but that's a different question than the timing of that spending.

But how much? Is this the story, or is our Government off on an ill-advised shopping spree during these hard times? 

Austan cites "automatic stabilizers"
"Most of the increase in the deficit during a downturn doesn't come from new policies in Washington. The deficit rises because both spending and taxes automatically adjust when the economy struggles. Unemployment insurance payments rise and more people qualify for Medicaid and food stamps. Incomes fall so people pay less taxes"
This, as far as I can tell, is not quite true. Here is the CBO's "cyclically adjusted deficit"

Source: http://www.cbo.gov/ftpdocs/114xx/doc11471/05-27-AutomaticStabilizers.pdf

Quoting from the CBO, "The budget balance without automatic stabilizers is an estimate of what the surplus or deficit would be if GDP was at its potential, the unemployment rate was at a  corresponding level, and all other factors were unchanged." Now, one can quibble with their calculation, but the "without automatic stabilizers" deficit is not even close to a flat line!

Austan is close to right however. It is true that our Government typically chooses to run larger deficits in recessions. It is also true that our current deficit choices are not out of line from the historical pattern, given the depth of the recession.  Here's a graph to make that point:
Surplus/deficit and output gap (GDP - potential), as percent of GDP

The red "gap" line is the percentage difference between GDP and "potential GDP."  (I don't put much stock into the "potential" concept, but it provides a nice trend line.) The blue line is the Federal surplus or deficit, also as a percent of GDP.

You can see that deficits regularly get much bigger in recessions. Roughly speaking, the deficit movement is just about equal to the GDP gap -- if GDP falls $100 billion, the deficit increases $100 billion. Our deficit, about 10% of GDP, corresponds to a 10% fall in GDP, consistent with the usual pattern. 

So, Austan is saying, in the tight confines of the WSJ's word count, that when the GDP gap (red line) recovers, if the Goverment follows the same choices as in the past, the massive deficits will largely disappear (blue line).

How do I keep worrying?

First, we will still have racked up an impressive debt.  Each year of deficits equal to 10% of GDP adds 10 percentage points to our debt/GDP ratio. Greece is out there not too far away. Even if the deficits pass, we still have to pay off the debt...Just as the "long term" problems settle in.

Second, look at the longer-term trends. 1969-1982 saw a steady deterioration in GDP and steady widening of the deficits. The strong growth in GDP from 1982 to 2000 corresponded with our first actual surpluses in a quarter century. But 2000 to now is starting to look suspiciously like another growth slowdown. If this is 1975 again, how long until we see 1999?

In other words, what if  GDP does not quickly recover to "potential?" Here's a graph to make the issue clearer.

The green dashed line is real potential GDP. You can see that actual GDP has fell about 10% below this trendline -- and is sitting there.  You can see huge increase in expenditures -- the rise in the red line by nearly 10 percentage points. Expenditures are sitting at 25% of potential GDP.  The huge fall in tax receipts is also striking, and they're stuck too. (Tax receipts depend on more than GDP. In particular, you can see the effect of the two big stock market declines in 2000 and 2008.)

To get GDP back to the trend line, we need 10 percentage points of extra growth, on top of the 2.5% per year or so of trend growth. That's two years of 7.5% growth, which nobody is forecasting any time soon. This "catch-up-to-trend" growth has been the pattern of past business cycles. But what if we keep stumbling along at 2.5% - 3% growth for many years, racking up trillion dollar deficits each year we do so?

Third, to make it just a little more scary, notice the subtle flattening of the green "potential" line. Trend growth itself is slowing down. The trend grew at 4% in the 1950 and 1960s, slowed to 3% through 2000. It is 2.5% in the 2000s and the CBO's forecast is down to 2.3% for the 2010s. 

Back to the family analogy: Yes, dip into savings or use the credit cards if you lost your job, but a new one is all lined up for 6 months from now. But maybe this family is facing a long and uncertain spell of unemployment,  and it's going to end up working at Wal-Mart for a lot less money than before. Racking up debt with alacrity isn't such a good idea in that case.

So I think both Austan and John are  right: Yes, this Administration (and Congress') spending response to the recession was not much different than previous ones. But it does not follow that long-run discretionary spending and debt accumulation are not a huge problem, even before the entitlements disaster hits. We may be looking at the long run!

Which brings us back to the beginning. "A fiscal grand bargain and growth strategy" really are important, perhaps more than Austan had in mind when he penned those poetic words! Catching up to trend, and then bending the trend upwards, will take some deep changes in how we do things.

Friday, January 6, 2012

SEC Charges Life Settlements Firm and Three Executives with Disclosure and Accounting Fraud

A Texas-based financial services firm, Life Partners Holdings Inc., and three of its senior executives have been charged by the SEC for their involvement in a fraudulent disclosure and accounting scheme involving life settlements. The firm failed to disclose risks, therefore misleading investors. Unknown to investors, the company was systematically and materially underestimating the life expectancy estimates, used to price transactions. These estimates have a large impact on the company’s revenues and profit margins as well as the company’s ability to generate profits for its shareholders. It is also alleged that they also utilized improper accounting to increase the companies value.

SEC Charges Life Settlements Firm and Three Executives with Disclosure and Accounting Fraud

Thursday, January 5, 2012

Should Greece Devalue?

Two weeks ago I wrote the following in a little Bloomberg column about the Euro 
Defenders [of devaluation] think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budget and economic troubles. Why do economists think Greek politicians are so much wiser? 
This paragraph set off a little kerfuffle in the Cochrane-is-a-moron section of the blogosphere. I won't respond in detail, because I presume you're more interested in economics than what anyone thinks of anyone else's intelligence.

But the paragraph was mighty distilled, and the evident interest in the question suggests a little fuller examination of whether devaluation is a good idea or not for a country like Greece, and trying to understand why people come to such different views.

I think I can sum it up this way: Devaluation is like a cigarette. The Keynesian camp basically says, "Boy, a cigarette would perk me up right now."' Modern macroeconomists (I'm looking for a good name -- "Dynamic?" "Intertemporal?" "Equilibrium?" Really everybody else, including new-Keynesians) basically say "Maybe, but smoking is a really bad lifestyle decision." We think of policies as rules, not decisions.

The following discussion resembles that between a teenager and the parent who found a pack of cigarettes. It sounds like facts are at issue -- just how good does it really feel, just how long does it take to get addicted, how bad are the long-run effects -- but there is a deeper difference in perspective, which is why the arguments are a lot more heated than the simple facts suggest. 

So, just how good is a cigarette anyway?

Devaluation works if prices and wages don't adjust. If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don't change, then Greek goods are cheaper and Greece will produce and export more. Similarly, inflation can goose output a bit. For example, if prices go up faster than wages, then companies will hire more workers and make more goods. (Standard disclaimer: I'm simplifying dramatically. Don't write that I'm an ignoramus because I can't get the whole modern theory of the Phillips curve into one sentence of a blog post written for a popular audience.) 

So, sometimes devaluation or inflation work, at least temporarily. We've known this for a long time. In his Nobel Prize address, Bob Lucas cites Hume in 1752.  "Temporarily" is an important qualification. We all agree (I hope) that money is neutral in the long run. Inflation eventually catches up to devaluation. Wages eventually catch up to prices. So even here, the question is just how long the high lasts before the hangover sets in.

And devaluation and inflation often don't work, or are indeed counterproductive. The US and many other countries in the 1970s experienced stagflation -- devaluation and inflation accompanied by worse economic performance. Most economic basket cases -- Zimbabwe was my example -- are junkies, continually inflating and devaluing. Most really successful countries -- Switzerland -- are famous for strong currencies. We've known that for a long time as well.

When does devaluation work? The most important consideration suggested by modern macroeconomics is whether the devaluation or inflation is expected or unexpected. This is the heart of Milton Friedman's famous AEA presidential address, and Bob Lucas' and  Edmund Phelps'  Nobel prizes. (Standard disclaimer.)

This will likely not work: the Greek government declares that on January 1 2013 it will change from Euros to New Drachmas at 2:1. I think we would all predict that "devaluing" in this way would have exactly the same effect on real prices and wages as joining the Euro did: none. On Jan 1 2013, prices, wages, contracts, bank accounts, etc. are just multiplied by 2 and a "D" replaces the "E" in front of the number. Whatever "price stickiness" means, this isn't it.

If the Greek government went on, "and then we will devalue the Drachma relative to the Euro by 5 percent per month," it still would have little real effect. With that announcement and a year to plan, Greece would simply return to an economy familiar to anyone who lived through the 1970s, steady 5% wage and price inflation.

The trick for Greece, in its current situation, is to change to a New Drachma, and convince everyone that new Drachma will have a stable value. Then, it has to surprise everyone by devaluing, or devaluing more than they expected.

That will be difficult to arrange. It could easily backfire. People could expect much more inflation and devaluation than the Government had planned. Money could fly out of the country, interest rates spike, and a panic wage and price inflation take off. Then Greece would get stagflation, not a boom.

Devaluation also "works" by engineering wealth transfers, from lenders to borrowers.  But you have to surprise the wealth in order to transfer it.

So, devaluation is not an "always and everywhere" proposition. Yes, if the US were to announce that we are pegging the dollar at $2 per euro, and the ECB went along with this policy, it's a good bet that prices and wages would not adjust overnight. Dollar goods would be cheaper in Europe, and the US would export more and import less for quite a while. Countries, who already have their own currencies, a good reputation, and stable values, can devalue unexpectedly and boost exports and output.  It does not follow that a return to the Drachma and devaluation will work for Greece.

The experience of small countries around the Eurozone is also not immediately applicable. They already have currencies. The combination of leaving a currency union, establishing a new currency and immediately devaluing it does not have much precedent. And for every Iceland, where devaluation helped, there is a Hungary, where it does not seem to be producing riches.

I don't deny that it could be done. But it's not so easy as the devaluation camp makes it sound.

But that's not even the main issue. How did I let the teenager drag me in to talking about how good it feels to smoke that first cigarette? Back to the nagging parent: is smoking a good lifestyle decision?

Is it better over the long run for a country like Greece to have its own currency, and routinely resort to devaluation and currency depreciation when its economy is in the doldrums or the government is discovered to have overborrowed? Or is it better to stick with the Euro, and rule that option out? Greece has plenty of experience with inflation, devaluation, and default. Much of the world was on a binge of inflation and depreciation in the 1970s. It didn't work out so well.

This is where modern macroeconomists and Keynesians start talking different languages. Modern macro discussions are full of words like "precommitment," "rules vs. discretion," "dynamic efficiency" that are absent in the cigarette-by-cigarette, live-for-today-for-in-the-long-run-we're-dead mode of Keynesian thinking.

Just one example: Before Greece joined the Euro, it paid very high interest rates. When it joined the Euro, all of a sudden it was able to borrow at German interest rates. It did, massively, as we know. Porsches went South, and pieces of paper flew North. Greece boomed. If the money had been properly invested, Greece would still be booming. The money was wasted, but the opportunity was there.

Now, why did joining the Euro give Greece this opportunity to borrow at low rates? Cynics say, because the Eurozone meant eveyrone thought Germany would bail them out, as people correctly expected the US to bail out Fannie and Freddie. But even I am not that cynical. The Eurozone was set up, remember, specifically denying sovereign bailouts.

A second explanation seems more plausible to me: by joining the Euro, Greece precommitted against devaluation.  It could no longer take the easy way out. If the economy got in trouble, Greece would feel much more pressure to fix it, not to rely once again on a quick bout of devaluation. If the government got in trouble, it would have to deal with a messy default, not a quick depreciation. And the Eurozone makes that default harder than Greece's many previous sovereign defaults.(A short history by Benn Steil here.)

Nonsmokers get lower health-insurance premiums. Non-devaluers get cheaper loans.  Precommittment has real benefits. We've known that for a long time too, at least since Ulysses had himself tied to the mast so he could hear the sirens.

Furthermore, countries like Greece with chronic devaluation and inflation routinely resort to capital controls, price controls, exchange rate controls and other interventions to prop up their currencies. Junkies start stealing. These steps ruin small open economies. 

There is still room for debate. At least now we have both views on the table, and you see that national currency with occasional devaluation vs. precommitting against devaluation and staying in the Euro is not such an easy question. Reasonable people can disagree. Unreasonable people can disagree more.  

A lot of the answer is also political, not purely economic. Does a country have solid enough political institutions so it will use devaluation only when really necessary, and not to get out of stupid policies which it really ought to fix instead? Does the teenager really have the willpower to only smoke occasionally?  Do you trust the patient to self-administer the morphine? That's part of a bigger political worldview on whether you trust the benevolent discretion of politicians or whether you think they need to be constrained by strong rules and institutions.

I come down on the latter side of the fence, but mine is most assuredly an opinion, based on thinking through all these considerations, not a Fact Of Nature.

Whew, I tried to get a lot in those 4 sentences!