After the ACA -- Crafting an Alternative to Obamacare

I gave a talk at Hoover, encouraging those of us who are less than fans to speak up and outline the alternative to Obamacare. Podcast here.

Repeal and status quo is not enough. We need to listen, and point out how a radically freed and competitive system will address the genuine concerns that motivate many to support the law despite its flaws -- preexisting conditions, health care for the poor, outrageous cost and so forth.

The essay "After the ACA" lays it out in some detail.  The talk is a lighter discussion of where we are, but emphasizes how sitting back and letting the ACA unravel will just lead to an even more expensive and incorherent system. Stand up and state the alternative.

A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, "A limited central bank." It's especially noteworthy in the context of Janet Yellen's nomination, discussion between Congress and Fed about how the Fed should be run, the Fed's focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment....

When I talk to Fed types about this, the usual answer is a version of "well, yes, we don't really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?"

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit "availability" and perceived bubbles:

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. ...

...We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

...Even though the [Fed's] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.

What should the Fed do?

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.

The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current "dual mandate," but

The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

You're getting a sense of what genies Charlie would like to put back in their bottles. It's a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed's legal authority.  Yet independence is a good thing:

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 

... in exchange for such independence, the central bank should be constrained from conducting fiscal policy... [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.

What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:

One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.

Rules are important,

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  

And for more reasons than usual: if the bank is following a rule, it's much less open to political criticism and able to preserve its independence:

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals

...assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

Charlie agrees: you can't have effective forward guidance without precommitment, and you can't have precommitment and discretion. Here is the slam at how taper talk roiled bond markets

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the "mandate" includes "financial stability," and detailed discretionary direction of credit flows. Charlie:

Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort.... the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

In fact, the bigger the fire house, the more the chance of fires:

I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next "fire sale."

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

"You can keep your bonds if you like them?"

The whole speech is good, I hope my excerpts get you to go to the real thing.

New vs. Old Keynesian Stimulus

While fiddling with a recent paper, "The New-Keynesian Liquidity Trap" (blog post), a simple insight dawned on me on the utter and fundamental difference between New-Keynesian and Old-Keynesian models of stimulus.

Old-Keynesian. The "Keynesian cross" is the most basic mechanism. (If you are worried that I'm making this up, see Greg Mankiw's Macroeconomics, p. 308 eighth edition, "Fiscal policy and the multiplier: Government Purchases.")

Consumption follows a "consumption function." If people get more income Y, they consume more C

C = a + m Y.

Output Y is determined by consumption C investment I and government spending G

Y = C+ I + G.

Put the two together and equilibrium output is

Y = a + mY + I + G
Y = (a + I + G)/(1-m).

So, if the marginal propensity to consume m=0.6, then each dollar of government spending G generates not just one dollar of output Y (first equation), but $2.5 dollars of additional output.

This model captures a satisfying story. More government spending, even if on completely useless projects, "puts money in people's pockets." Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.

New-Keynesian. The heart of the New-Keynesian model is a completely different view of consumption. In its simplest version

Here consumption C, relative to trend, equals the sum of all future real interest rates i less inflation π i.e. all future real interest rates. The parameter σ measures how resistant people are to consuming less today and more tomorrow when offered a higher interest rate.

(This is just the integrated version of the standard first order condition, in discrete time

People in this model think about the future when deciding how much to consume and allocate consumption today vs. tomorrow looking at the real interest rate. I've simplified a lot, leaving out trends, the level and variation of the "natural rate" and so on.)

In this model too, totally wasted government spending can raise consumption and hence output, but by a radically different mechanism.  Government spending raises inflation π . (How is not important here, that's in the Phillips curve.) Holding nominal interest rates i fixed, either at the zero bound or with Fed cooperation, more inflation π means lower real interest rates. It induces consumers to spend their money today rather than in the future, before that money loses value.

Now, lowering consumption growth is normally a bad thing. But new-Keynesian modelers assume that the economy reverts to trend, so lowering growth rates is good, and raises the level of consumption today with no ill effects tomorrow. (More in a previous post here)

Comparing stories

This new-Keynesian model is an utterly and completely different mechanism and story. The heart of the New-Keynesian model is Milton Friedman's permanent income theory of consumption, against which old-Keynesians fought so long and hard! Actually, it's more radical than Friedman: The marginal propensity to consume is exactly and precisely zero in the new-Keynesian model.  There is no income at all on the right hand side. Why? By holding expected future consumption constant, i.e. by assuming the economy reverts to trend and no more, there is no such thing as a permanent increase in consumption.

The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don't think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

Models and stories

Now, why is Grumpy grumpy?

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people's pockets, and then they go and spend, and that puts more money in other people's pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It's just not economics. A 40 year quest for "microfoundations" came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation -- but they had not been able to publish any of their models in peer-reviewed journals for 35 years.

What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it's also fashionable to use new-Keynesian models as holy water. Something like "well, I didn't read all the equations, but Woodford's book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again." Cognitive dissonance allows one to make these contradictory arguments simultaneously.

Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: "The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow's consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier," sorry, our new models have no such effect, and we'll stand up in public and tell any politician who uses this argument that it's wrong."

That, at least, would be honest. If not particularly effective!

You may disagree with all of this, but that reinforces another important lesson. In macroeconomics, the step of crafting a story from the equations, figuring out what our little quantitative parables mean for policy, and understanding and explaining the mechanisms, is really hard, even when the equations are very simple. And it's important. Nobody trusts black boxes. The Chicago-Minnesota equilibrium school never really got people to understand what was in the black box and trust the answers. The DSGE new Keynesian black box has some very unexpected stories in it, and is very very far from providing justification for old-Keynesian intuition.

The Next Obamacare Fiasco

Thousands Of Consumers Get Insurance Cancellation Notices Due To Health Law Change Kaiser Health News

Some health insurance gets pricier as Obamacare rolls out Los Angeles Times

Kaiser:

Health plans are sending hundreds of thousands of cancellation letters to people who buy their own coverage,...The main reason insurers offer is that the policies fall short of what the Affordable Care Act requires starting Jan. 1

Florida Blue, for example, is terminating about 300,000 policies, about 80 percent of its individual policies in the state. Kaiser Permanente in California has sent notices to 160,000 people – about half of its individual business in the state. Insurer Highmark in Pittsburgh is dropping about 20 percent of its individual market customers, while Independence Blue Cross, the major insurer in Philadelphia, is dropping about 45 percent.

LA Times:

Blue Shield of California sent roughly 119,000 cancellation notices out in mid-September, about 60 percent of its individual business. About two-thirds of those policyholders will see rate increases in their new policies....

Middle-income consumers face an estimated 30% rate increase, on average, in California due to several factors tied to the healthcare law. Some may elect to go without coverage if they feel prices are too high. Penalties for opting out are very small initially. Defections could cause rates to skyrocket if a diverse mix of people don't sign up for health insurance

This is interesting. Obamacare could actually increase the number of people without insurance, because you are not allowed to keep (consumer) or sell (insurance company) simple cheap insurance.


If you're healthy and have been paying for individual insurance all along -- largely because you know people with preexisting conditions can't get insurance, and you want to lock in your right to continue your policy should you get sick -- there is now a strong incentive to drop out.

The government has just wiped out the value of those premiums you paid all these years -- you don't need the right to buy health insurance anymore, as you can always get it later. You're seeing a large increase in premiums for benefits you don't want and to cross-subsidize other people. The mandate penalties are almost certainly going to be pushed back, they penalties are a good deal less than the cost of health insurance (which you can always get later if you get sick), the IRS has already said it's not going after people who don't pay them. Dropping out of individual health insurance starts to make a lot of sense.

This was bad enough on its own. But if insurance companies cancel these people's policies, all at once,  it's dramatically worse. It would be hard to design a more effective "nudge" to get such people to think about it and conclude that dropping health insurance is a good idea.

The overall numbers may not change. Other reports suggest that poor and sick people have been signing up in droves, mostly to get on the expanded medicaid. But it's an obvious fiscal disaster if Obamacare only attracts the poor and sick, does not attract the young and healthy -- and now drives away the healthy people who were provident enough to buy individual health insurance!

Why is this happening? A curious tidbit

All these cancellations were prompted by a requirement from Covered California, the state's new insurance exchange. The state didn't want to give insurance companies the opportunity to hold on to the healthiest patients for up to a year, keeping them out of the larger risk pool that will influence future rates.

The destruction of the off-exchange individual insurance market is deliberate.

The best quote of the bunch, from the LA Times

Pam Kehaly, president of Anthem Blue Cross in California, said she received a recent letter from a young woman complaining about a 50% rate hike related to the healthcare law.

"She said, 'I was all for Obamacare until I found out I was paying for it,'" Kehaly said.

This realization will come soon to millions more.

Krugtron parts 2 and 3

Niall Ferguson has completed his Krugtron trilogy, with Part 2 and Part 3, (Part 1 here FYI, which I blogged about earlier.)

Part 2 continues Part 1. In fact, Krugman is as human as the rest of us, and the future is hard to see. Niall compiles a long record of what Krugman actually said at the time. As before, those of us on the sharp end of Krugman's insults enjoy seeing at least his own record set straight.

But Niall admits what I said last time: we don't really learn much from anyone's prognostication

In the past few days, I have pointed out that he has no right at all to castigate me or anyone else for real or imagined mistakes of prognostication. But the fact that Paul Krugman is often wrong is not the most important thing. ..

What Niall is really mad at are the insults, the lying and slandering (I'm sorry, that's what it is and there are no polite words for impolite behavior), and the lack of scholarship -- Krugman does not read the things he castigates people for.

And it matters.

Insults

Why have I taken the trouble to do this? I have three motives...to assert the importance of humility and civility in public as well as academic discourse..

...his hero John Maynard Keynes did not go around calling his great rival Friedrich Hayek a "mendacious idiot" or a "dope".

The "Always-Wrong Club" is just the latest of many ad hominem attacks he has made on me since 2009. On one occasion he implied that I was a racist and then called me a "whiner" when I objected. On another he referred to me as a "poseur", adding for good measure that I had "choked on [my] own snark". Last year he wildly accused of making "multiple errors and misrepresentations" in article for Newsweek, only one of which he ever specified. More recently I was accused of "trying to flush [my] own past statements down the memory hole" - a characteristically crude turn of phrase - and of being "inane". Re-reading these, I can only marvel at the man's hypocrisy, for Krugman often sanctimoniously denies that he "does ad hominem" - and once had the gall to accuse Joe Scarborough of making such an attack on him when Scarborough merely quoted Krugman's own words back at him...

Lying

... Krugman has repeatedly misrepresented what I said in that debate. Immediately afterwards, he cynically claimed on his blog that I had been arguing that high deficits would crowd out private spending. Later, in order to have a straw man for his vulgar Keynesian claim that even larger deficits would have produced a faster recovery, he started to pretend that I had predicted "soaring interest rates" and had called for immediate austerity.... But anyone who reads the transcript of our debate - even the edited version that was published - can see that this was not my position.

Scholarship

 When Paul Krugman first began his attacks against me, he made it clear - as if almost proud of the fact - that he had read none of my books. (Quote: "I'm told that some of his straight historical work is very good.") 

Krugman's unabashed ignorance of my academic work raises the question of what, in fact, he does read, apart from posts by the other liberal bloggers who are his zealous followers. ... (When he does read a book, he mentions it in his blog as if it's a special holiday treat.)

It matters

It is "my duty, as I see it, is to make my case as best I honestly can," Krugman has written, "not [to] put on a decorous show of civilized discussion." Well, I am here to tell him that "civilized discussion" matters. It matters because vitriolic language of the sort he uses is a key part of what is wrong with America today. As an eminent economist said to me last week, people are afraid of Krugman. More "decorous" but perhaps equally intelligent academics simply elect not to enter a public sphere that he and his parasitical online pals are intent on poisoning. I agree with Raghuram Rajan, one of the few economists who authentically anticipated the financial crisis: Krugman's is "the paranoid style in economics": 

`All too often, the path to easy influence is to impugn the other side's motives and methods ... Instead of fostering public dialogue and educating the public, the public is often left in the dark. And it discourages younger, less credentialed economists from entering the public discourse.' 

The originals are full of links to documentation (a good historian's habit) which I could not reproduce here.

There is a reason the rest of the world -- especially the academic world -- abides by a simple set of ethics that include: read what you criticize, document what you say, try to understand the other side's view, respect their integrity, don't lie, don't insult, don't deliberately misquote, attack ideas if you will but not people, don't make up slanderous allegations about your opponents personal motives, and (hello, New York Times) check your facts.  And when you see someone flagrantly violating these rules, tune out.

Some interesting New York Times inside commentary.

PS: My last post on this resulted in a whole lot of nasty Ferguson's-a-crank comments, which I deleted. You may criticize Ferguson, but do so politely and factually.

Mulligan on Obamacare Marginal Tax Rates

Casey Mulligan wrote a nice Wall Street Journal Oped last week, summarizing his recent NBER Working Paper (also here on Casey's webpage) on marginal tax rates.

What do I mean, tax, you might ask. Obamacare is about giving people stuff, not taxing. Sadly, no. Obamacare gives subsidies that are dependent on income. As you earn more, you receive fewer subsidies for health care, reducing the incentive to earn more. Casey tots this sort of thing up, along with the actual taxes people will pay.

Economists use the word "tax" here and we know what we mean, but it would be better to call it "disincentives" so it's clearer what the problem is, and just how painful we make it for poor people in this country to rise out of that poverty.

As you can see, the average marginal "tax" rate went up 10 percentage points since 2007, and about 5 percentage points due to Obamacare alone.

Going back to the working paper, I think this is actually an understatement. (Probably the first time Casey or I have ever been accused of that!)


First, not even Casey can add everything up, and it all adds in one direction. State and local taxes, and vast number of state, county, city and other income or asset-based transfers all add. I haven't read all his papers or the whole book yet, but did Casey get them all? For example, I just got in the mail notice for a little program offered by the state of Illinois to lower your property taxes if you earn less than $100,000 per year. Nice, but one more little incentive not to earn more than $100,000 per year, and not in Casey's calculation.

In email correspondence, Casey pulled me back from these thoughts in a way that is revealing about the calculation. I wanted to add sales tax. After all, if you earn a dollar, but you have to pay 10% sales tax to do anything with it, that's another 10% distortion, no? Casey responds no, because he wants to measure the income-compensated distortion to labor, period. If you don't work, and somehow you also get income, you still have to pay the 10% sales tax. So the sales tax does not distort that pure work-no work decision. Casey's right, but I think this clearly illuminates the conservative nature of his calculation and what it means. There are a lot more margins, wedges, and distortions out there, and he's not trying to measure them all. He's also not trying to measure the wedges and disincentives for employers to hire people, towards non-market activities, and certainly not the effects of the regulatory tangle.

Another note of conservatisim: "The results account for the fact that many people will not participate in programs for which they are eligible." This is an important issue, that at least had not sunk in for me until reading a recent CBO report. People don't sign up for all the benefits to which they are eligible. If they did, marginal tax rates would be astronomical. It also sends a warning: Just how long will it be before people in an increasingly stagnant economy figure out all the programs they are eligible for?

Drawing a single line can also be unduly calming. You might say, "well 50% isn't so bad. Europeans still work, sort of, paying 50% marginal tax rates."  But as Casey reminds us, the spread in marginal tax rates across people is enormous. For example, the paper has a nice example (p. 13, table 2) of how a typical earner will come out ahead by choosing to work part time and receive subsidies, rather than work full time. This is a case of a 100% marginal tax rate.

It's likely that the effect of marginal taxes is nonlinear. Much of the labor decision comes in chunks: work or don't work; work part time or full time; apply for benefits or don't, with transactions costs and irreversibilities.  Suppose half the population feels a 100% marginal tax rate and half feels zero. Half the population works, half does not. That is likely a much larger effect than if the whole population felt a 50% marginal tax rate.

In sum, it's probably worse than even Casey's graph. But Casey is doing the right thing in putting up a carefully documented graph and paper rather than speculating. Speculation is for blogs, not papers and not for good opeds.

And Casey's big point remains the additional effect of Obamacare and other changes to Federal programs. Whatever you think the level is, it's now 10 percentage points more than what it used to be. On average.

Margins on Exchanges

A nice Bloomberg View by David Goldhill offers an Econ 101 lesson in incentives. Though the average subsidy rate to health insurance is limited, the marginal subsidy rate is 100% once consumers hit the income limits -- so many consumers have no incentive at all to shop for lower prices. In turn, this greatly lowers the chance that insurers will compete on price.

David:

Let’s take an example. A family of four at 138 percent of the poverty level ($32,499) has its premium capped at 3.29 percent of income or $1,071. The rest is subsidy. So, if the cost of a silver plan is $10,000, the subsidy for this family is $8,929. A family at 400 percent of the poverty level ($94,200) has to pay up to 9.5 percent of its income for a plan, or $8,949. So the same $10,000 premium carries a subsidy of only $1,051.

But now look at those two families from the insurer’s perspective. A $10,000 plan already costs more than the maximum amount either family would pay. If the insurer raises the premium to $10,001, both families get $1 in additional subsidy. If it raises premiums to $11,000, both families get $1,000 in additional subsidy. In other words, no matter how much an insurer raises rates, a subsidized household pays zero more.

Of course, it takes some cleverness for insurance companies to separate out these now totally price-insensitive buyers from regular customers, and David explains some of the ways they can do so. Having seen the airlines at work, you get a sense of just how clever companies can be. Modern big-data driven marketing is all about careful price discrimination.

A more well known incentive problem: A rule that you must spend 80% of what you take in can limit profits. Or it can incentivize wasted spending.

In what may be the single greatest source of unintended consequences in the Affordable Care Act, insurers are now required to spend at least 80 percent of revenue from premiums on care. Superficially, this means that if they set premiums too high, they will have to eventually refund much of the money that they don’t end up spending on care. But let’s say you’re running an insurance company. You can find ways to spend more money on beneficiaries’ health care -- say, with more generous definitions of free preventive care, more expansive rehabilitation services or higher reimbursement rates on doctors’ services -- and keep 20 percent of the all money you bring in. Or alternatively, you can spend less on care and give refunds. Easy choice.  

Update: I don't know why I didn't think of this before... Cash rebates! Just like credit cards. OK, we can't be so obvious, points on your credit card, free miles, toasters, checkups for your cat...Each dollar added to the premium comes from the government, so attract customers by the closest thing you can get away with to cash back.

Ferguson on Krugtron

A fun show is breaking out. Niall Ferguson on "Krugtron the invincible."

Paul Krugman, for a while now, has been lambasting those he disagrees with by trumpeting their supposed "predictions" which came out wrong, and using words like "knaves and fools" to describe them -- when he's feeling polite. These claims often are based on a rather superficial, if any, study of what the people involved actually wrote, mirroring the sudden narcolepsy of Times fact-checkers any time Krugman steps in to the room. Niall has lately been a particular target of this calumnious campaign.

Niall's fighting back. "Oh yeah? Let's see how your "predictions" worked out!" Don't mess with a historian. He knows how to check the facts. This is only "part 1!" Ken Rogoff seems to be on a similar tear. (and a new item here.) This will be worth watching.

As regular blog readers know, I don't think science advances by evaluating soothsaying. You make good unconditional predictions with very badly wrong structural models, and very good structural models make bad unconditional predictions.  The talent of predicting and the talent of understanding are largely uncorrelated.  The judgmental forecasts of individuals are poor ways to evaluate any serious economic or scientific theory.  I carefully don't make "predictions" for just that reason. So, I don't regard this cheery deconstruction effort as a useful way to show that Krugman's "model," whatever it is, is wrong. I also can't see that anyone but the devoted choir of lemmings is paying much attention to Krugman's mudslinging any more.  But it is nice that Niall and Ken are taking the effort to ask the great doctor if perhaps he also doesn't need a bit of healing; perhaps they will force Krugman to go back to actually writing about economics. 

Update: Benn Steil Chimes in, this time on the Baltics, Iceland, and the supposed wonders of currency devaluation.

Rogoff on UK Defaults

Ken Rogoff wrote a very interesting FT oped on UK finances (FT original, Rogoff webpage if you can't see FT.)

The issue: Should we worry about huge sovereign debts of advanced countries? Or was the only problem with fiscal stimulus that it was not big enough?


A little history:

Yes, from the 1800s until the first world war, the UK was a global superpower that commanded vast colonial resources and investments. Over long periods, these foreign assets yielded returns well in excess of interest on debt. But comparing government debt ratios back then, when the UK was a massive net creditor, to debt ratios today, when British foreign liabilities exceed foreign assets, is utterly misleading. Moreover, back in the 1820s, the UK was pioneering the industrial revolution; things are not quite the same today. Back then, the UK did not have to worry about pension liabilities or existential threats to the banking system that could require massive injections of cash to fix. ...

During the 1930s, Britain defaulted on debt to the US accumulated during the first world war and its aftermath. ...

It is often stated that after the second world war the UK debt reached almost 250 per cent of gross domestic product and was brought down merely through growth and inflation. This is a myth ...

Then there is the high-inflation era of the 1970s – another de facto default. Last but not least, what about the UK’s serial dependence on International Monetary Fund bailouts from the mid-1950s until the mid-1970s? This is hardly a country with an indestructible credit status. ...

Being a UK bondholder has had its ups and downs.

Looking forward, an important point: a country needs to be substantially below its ultimate borrowing limit, or it loses its ability to fight crises going ahead.

..a euro collapse would have triggered a stampede out once investors realised that the UK banks and trade would be savaged, a flexible currency notwithstanding. In that scenario, UK leaders would have been forced to close massive budget deficits almost overnight. That would have been truly catastrophic austerity. ...

We now know the euro did not collapse. [yet -- JC] With 20-20 hindsight, yes, the UK could have borrowed more. But we do not have hindsight at the moment decisions have to be taken. 

Kan and Carmen Reinhart have been at the receiving end of Paul Krugman's tender commentaries lately, and I'm interested to see Ken taking up the issue. Krugman likes to lambaste people for "predictions" that he imagines they made which didn't come out. On the euro blowing up, Ken seems to be offering a taste of his own medicine, made more bitter by the fact that Krugman actually did say what Ken says he said:

...This was the big call – the one that everyone was focusing on. To state that credit risk was gone by 2010 is ludicrous. None other than The New York Times columnist Paul Krugman prognosticated the euro’s early demise regularly from April 2010 to July 2012. His big call has turned out – so far – to be dead wrong.

I will be curious if we see more of that from Ken. Stay tuned.

Financial Reform in 12 Minutes

I was on a panel yesterday at a fascinating conference, "The US Financial System–Five Years after the Crisis."  The conference was run simultaneously at Hooover and Brookings, with a live video link. Which went dead exactly as I was proclaiming the wonders of modern technology, but otherwise worked remarkably well. Alas, the conference was run under "Chatham house rules" so I can't tell you all the remarkable things that the Very Important People said. I can pass on surprise that there was so little disagreement between the Brookings and Hoover sides. I was expecting a spirited defense of Dodd-Frank from the East. Instead, they piled on it, if anything more eloquently that the West, with only one very thoughtful but still lukewarm defense.  I hope the presentations will eventually be made public, as they were uniformly interesting -- even the ones I disagreed with I thought were wrong in very interesting and thoughtful ways.

I was given 12 minutes to comment on the state of financial reform, is too big to fail over, are we ready for the next crisis. My answer follows. Yes, faithful readers will recognize something of a moving average, which will continue both to move and to average.

Have fun

Financial Reform in 12 Minutes

Is too big to fail over? No. Are we ready for the next crisis? Absolutely not. 

The Dodd-Frank act is “more cowbell” – a dramatic expansion of the same regulatory structure that failed before. Unless fixed, it will fail again in even more spectacular fashion.

The basic structure of Dodd-Frank is a huge expansion of regulation – largely “discretionary, judgmental, and micro-managing” as nicely put by an earlier panelist – to try to prevent any large and “systemically important” institution from losing money again, and a “resolution authority” in place of bankruptcy court should it fail anyway.

The premise of “resolution authority” is that large financial institutions are too complex to go through bankruptcy.  So instead, the mess will be dumped into the lap of appointed officials who will figure out over a weekend who gets how many billions of dollars. If it is so complex that bankruptcy can’t fixed, to write down ahead of time who gets what, how in the world are these poor folks going to figure it out on the spot?  This idea is a triumph of discretion over rules.

They won’t. Politically powerful creditors will scream that they too are too “systemic” to lose money, much as Goldman Sachs threatened if it should not get its collateral from AIG.  “Resolution” only matters with a crisis in the background as in fall 2008, amid general panic. Of course these large and well-connected creditors will be bailed out.

Seeing this in advance, and all the rules up for grabs, other creditors will run at the first hint that resolution might be coming. Seeing that run develop, the FSOC will be forced to bail out ahead of time.

The pretense that regulators can and will spot trouble brewing and stop banks from taking risks, as they abundantly failed to do in 2008, and again when faced with European sovereign defaults, is a triumph of hope over experience.

The “macroprudential” idea that the Fed can spot “bubbles” forming, and can and will stabilize asset prices by artfully controlling interest rates, intervening in many markets, and controlling the details of financial flows, so that nobody loses any money in the first place, is a triumph of pipe dreaming. (An earlier panelist eloquently called it “profoundly misguided.”)

Like all previous crises, the next crisis will not conveniently repeat the last one, with a real estate boom and bust provoking a run in shadow banking. It will erupt from an unexpected quarter. What out there today looks today like subprime mortgages did in 2004? Sovereign debt is a good possibility.  Europeans have learned that buying the bonds of high-yield “do what it takes” countries makes money, as Americans learned for subprime mortgages. A realization that sclerotic growth is settling in as the new normal, upending long-term budget projections, could be the trigger.  Detroit could be LTCM, California, Illinois, and Greece could be Bear Stearns, and Italy could be Lehman Brothers.

We used lots of sovereign debt to bail out of the last crisis and stimulate in its wake. Issuing more sovereign debt remains our and Europe’s fire extinguisher. We are utterly unprepared for a crisis of sovereign debt itself.

There is an alternative.

The crisis was a run. The tech stock bust did not cause a crisis, because tech stocks were stocks. When stock prices fall, it’s too late to run. The housing bust led to a crisis because houses were funded, in the end, by overnight debt, which ran.

Institutions are not systemically dangerous. Run-prone assets are dangerous.

So, why not just ban run-prone assets? We could require that all run-prone fixed-value liabilities, including deposits, overnight debt, and money-market shares, must be backed 100% by short-term treasuries; ideally in separate or at least ring-fenced institutions.  Mortgage-backed securities can be held, without government guarantee, via long-only, floating-value mutual funds in your and my 401(k) accounts, by pension funds and by endowments. Banks, and everyone else, must then finance risky investments primarily by equity, with perhaps some long-term debt. Equity will no longer be just a “cushion” but a main source of funds.

Why not? The bank answer is “the Modigliani-Miller theorem fails for banks, so borrowing will be more expensive.” The MM theorem does indeed fail – because the government subsidizes and guarantees debt! Sure, banks want to maximize the value of those subsidies, and greater equity dilutes them.  In addition, even if equity-financed banks charged 20 basis points more for loans, in equilibrium, remember that we lost almost 10% of GDP and 10 million jobs 5 years ago, and they have not yet returned. That’s a big price to pay.  If we want to subsidize borrowing, we can do it transparently, on budget, rather than by subsidizing or even tolerating run-prone debt.

The other answer is, people need a large supply of fixed-value “liquid” assets to make transactions. It is said that we need banks to “transform” liquidity and maturity, even if imperfectly.

That may have been true in 1938. In 2013 financial, transactions, and communication technology have  changed everything. Instant communications – technical change – and index funds – financial engineering -- mean you no longer need fixed-value, first-come-first-serve, run-prone assets to have perfect liquidity. You could bump your iphone and pay for coffee by selling an S&P index fund share, and the store buys a share in a floating NAV mortgage-backed security fund, all in milliseconds. In fact, most current transactions are simply netted by banks, with nothing exchanged. In the 1930s we could not look up the value of the stock index to make the transaction; we needed to offer a fixed-value claim. Now we can.  2013 index funds and ETFs carry none of the asymmetric-information illiquidity that 1938 individual stocks suffer.  And, as a minor benefit of our fiscal profligacy, $18 trillion of Treasuries can back every imaginable genuine economic need for fixed-value run-prone debt.

How do we get there? Much – much – higher capital requirements are a good first step. But they choke on two practical problems: First, what’s the denominator? Risk weights can be gamed, and prescribing a ratio of capital to total assets incents banks to find clever ways to take on more risk at the same asset value. It’s not hard to buy beta. Second, what’s the minimum? 20%? 50%? 100%? The right answer is “the more the better,” and “so big that it doesn’t matter,” but that’s hardly satisfying.

I think a simple tax is the answer – though since “tax” is a dirty word, let’s call it a “systemic externality fee” – on debt, and especially on short-term debt or any other contract where the investor has the right to demand payment, and fail the firm if not received.  Every dollar of such funding will cost, say, a 10 cent fee. Payments due later generate smaller fees. I think we’ll see a lot less run-prone debt, fast. (We could at least stop subsidizing debt!)

Then, we won’t have to argue about risk weights and precise capital ratios, we won’t have to intensively regulate bank assets, we won’t tempt regulatory arbitrage, we won’t ask the Fed to decide whether houses in Palo Alto are a “bubble,” we will not hear the periodic call “we must recapitalize the banks” (at taxpayer expense), and, most of all, we can escape the chokehold on competition and innovation posed by our current expanding regulatory mess, together with the capture, cronyism, and politicization to which it is swiftly leading.

We need a financial system that can absorb booms and busts without creating a run or a crisis, rather than dreaming that regulators can produce a world without booms and busts. We need to regulate financial institutions’ liabilities, not micro-manage their assets, and especially not try to manage the price of every asset in which they might invest. We must escape this crazy system in which our government subsidizes debt, guarantees debt, increases the demand for debt by regulating it as a safe asset, and then tries to regulate financial firms away from issuing that debt.

We need to insulate the financial system from looming government financial trouble rather than more deeply intertwine them.

Update: John Taylor posts the conference program; Russ Roberts asked a great question 

Miron and Rigol go after a classic

Jeff Miron and Natalia Rigol have a provocative working paper, "Bank Failures and Output During the Great Depression." They take on one of Ben Bernanke's most famous papers.

Bernanke concluded that the great depression was severe not because of a lack of money-- medium of exchange -- but because of the credit effects of so many bank failures.

You may say, "duh," but it's not so easy. If bank A fails, what stops you from going and getting a loan from bank B? Well, if your ability to get a loan is wrapped up in the knowledge that employees of bank A have about you. And if, as a result of some sort of friction, Bank B doesn't hire those people for their knowledge. And if, as a result of another friction, someone can't come buy the assets of Bank A, including people and knowledge, and continue to operate the bank. In the great depression, restrictions on branches and interstate banking did that. The process is, fortunately, much swifter now that the assets of a small local bank can be swiftly bought up by other banks even out of state.

Bernanke's paper was - and is -- enormously influential. It was part of a movement to put credit rather than money at the heart of monetary economics and understanding of Fed policy.

But, as Jeff and Natalia point out, what if the banks fell because output was going down, not the other way around? How strong was Bernanke's actual evidence?

Source: Jeff Miron and Natalia Rigol

The graph, from the paper, makes the basic point. We can argue about the "bank holiday" but you see that even the other failures came rather late in the game. It's not at all obvious that bank failures cause output declines and not the other way around.

And of course, "the economy will tank if banks go under" is the mantra that produced the bailouts. Jeff and Natalia's closing words:

To the extent U.S. experience during the Great Depression – and especially the view that bank  failures played a significant, independent role during that period – formed the intellectual foundation for  Treasury and Fed actions, however, our results suggest a hint of caution. If the Great Depression does not constitute evidence for Too-Big-to-Fail, then what historical episodes do provide that evidence? We leave  that question for another day

There are lots of important unsettled issues, justifying Jeff and Natlia's cautious tone in the paper.  How about regional evidence -- didn't  towns whose banks failed suffer more than others, and had lower loan volumes? (I vaguely remember seeing that.  I don't pretend to be an expert on empirical great depression work. If someone has the cross-sectional evidence, add a comment.)

Still, given how the "credit channel" view underlies most of Fed thinking, even though inequalities by definition don't always bind, and how deeply the "we can't let banks fail or there won't be any new lending" view underlies so much crisis policy, I salute a careful reexamination of even classic "facts."

Update:

On the cross-sectional point, Hanno Lustig found Hal Cole and Lee Ohanian's "Reexamining the contributions of money and banking shocks to the U.S. great depression" and suggests this graph as a summary. Not even in the cross section. Thanks Hanno!

Source Hal Cole and Lee Ohanian

Is QE contractionary?

I ran across a fascinating blog post by Peter Stella at Vox-Eu on exit strategies and QE. 

Peter points out that only banks can hold reserves, while anyone can hold short term Treasuries. And you can easily use Treasuries for collateral.  That means that short term Treasuries are in some sense more liquid than reserves, and that by buying huge amounts of Treasuries and issuing reserves, the Fed may be actually contracting. 


In Peter's words:

Large Scale Asset Purchases (LSAPs) have inadvertently caused a significant change in the composition of assets available in the open market.

• The stock of marketable, highly liquid, AA+ collateral fell by trillions (disappearing into the Fed’s portfolio, i.e. System Open Market Account).
• The stock of assets available only for interbank trade (bank reserve deposits at the Fed) rose by trillions.

..Treasuries and Fed deposits are equally safe. But they differ significantly in their marketability. Anyone can trade Treasury securities; only banks can exchange Fed deposits. ... 

• Banking and money creation has not worked for at least two decades in the way that most people learned in school.

The old system was rather simple in the textbooks. The basic assumptions were (i) all credit was provided by banks; (ii) all bank credit (assets) were funded by the issuance, or creation, of depository liabilities (money) subject to a reserve requirement; and (iii) central banks controlled credit/money/inflation by rationing bank reserves. A stable 'money multiplier' was hypothesised to allow central banks to accurately predict the eventual impact of changes in bank reserves on money and credit. 

The problem with the old theory of monetary operations is that none of the three assumptions has been true for at least a generation. 

Most credit in the US is created by nonbanks; virtually all bank lending is funded by the creation of liabilities that are not subject to reserve requirements,3 and central banks do not ration reserves. In fact they take great pains to provide banks with the amount of reserves they desire. Central banks influence credit not by rationing the quantity of reserves but by altering the interest rate that banks must pay to obtain the quantity of reserves they desire.

• Today, credit creation in general and money creation in particular are no longer tied to the stock of reserves (i.e. the stock of banks’ deposits at the Fed).

Today, bank deposits at the Fed have only one real role – to facilitate management of the payments system. They are used to settle transactions among banks. Thus:

• The old notion that the quantity of bank reserves constrains lending in a fiat money world is completely erroneous.
• Traditional monetary policy has virtually nothing to do with money.4

....Plainly the stock of reserves is no longer connected to credit or meaningful measures of “money” via the old-notion of a reserve-ratio-based money multiplier. 

I don't buy it all, and I think some of the magic properties of treasuries as collateral and money are a bit overstated. But I'm collecting interesting stories by which it might be the case that current monetary policy has the opposite of the intended sign or other unexpected effects.  Peter certainly offers an interesting example.

He also points out that simply raising interest paid on vast reserves may have different effects than conventional policy which rations reserves. At a minimum he corrects my frequent assertion that reserves and Treasuries are perfect substitutes. No, Treasuries might be more "liquid''!

(Thanks to Thorvald Moe for pointing me to this interesting post.)

 

McDonalds and the minimum wage

Recently, on a long car trip returning from a glider contest, I did something unusual among our liberal elite: I actually went to a McDonalds and ate there.

The lady who took my order must have been about 19, as were all the other employees I could see, and pretty clearly new on the job.  Getting the order right took some effort.  I made the mistake of paying cash. The bill was something like $7.62. I first offered a $10, and she rang it up. Then I found 12 cents in my pocket, and offered it. This was a big mistake, as the cash register had already computed my change, and adjusting to my offer of 12 cents was beyond her abilities.

Most people might have been annoyed, but as an economist and an educator, I'm happy to see human capital building. OK, I was a little annoyed.

Which brings me, of course, to the proposals for a sharply increased minimum wage.

In the end, there really isn't much argument about what a substantially higher minimum wage will do.

Let us not deny the benefit. For the few people who work at minimum wage, but have worked their way up the ladder enough that they will keep their hours; who are actually trying to support themselves and a few children on these meager wages, it will mean a modest rise in income. The rise may be more modest once you account for taxes and reductions in transfers.  There weren't any such people at my McDonalds, but NPR and the New York Times seem able to find them.

That transfer comes from somewhere. Some of it comes from a wealth levy on existing McDonalds shareholders. If a regulation lowers a company's profits, the stock price declines. Then the rate of return going forward is the same as always. So it's a one-time wealth tax on the existing shareholders. Economists are supposed to like wealth taxes, with an asterisk that it makes future investors a bit skittish.

Some of it comes from higher prices. I read estimates that a big mac might go up from about $3.00 to about $3.50, and dismissed those price increases as a small burden to bear.  Looking around my McDonalds, I found this argument less persuasive. Because, of course, the kind of people who work at McDonalds are also the same kind of people who eat at McDonalds. If you're working at minimum wage in the middle of Oklahoma, you don't go out to a nice Greenwich Village restaurant to sample organic free range locally grown non-GMO gluten-free artisanal nuts and berries. McDonalds is a treat. And a pretty nice one at that. It's clean, healthy -- yes, some offerings are  full of sugar and fat, but not of e coli, and you can get the grilled chicken if you want -- and reasonably tasty. Raising prices from $3.00 to $3.50 is not a small matter if you earn under $10 per hour and you're feeding a few kids too.

Still, that is the benefit.

The cost is just as easy to forecast. McDonalds cuts hours, and uses its most experienced and efficient workers more, and fewer people like my hapless server. And they don't get the oh-so-needed on-the-job training. The biggest impact of minimum wages is not so much on existing workers, but on new workers entering the labor force. (See a nice new NBER working paper by Jonathan Meer and Jeremy West.)

The effects fall heaviest on low-skill teenagers, especially minorities. Tom Sowell is eloquent on this point, for example in a recent New York Post OpEd. I was unaware until reading it that minimum wage laws were initially backed in part as conscious efforts to discriminate against minorities and preserve jobs for white people. Sometimes, I guess, policies do have their intended effects.

This much is pretty obvious. Looking around my McDonalds, though, I could see a deeper possibility -- an unexplored avenue for substitution away from low-skill labor.

source: chownow.com

Why, I wondered, after 10 minutes in line and the third effort to get my simple order right, did I not simply enter my order on my iphone, and then it's ready for me when I step up to the counter? Or why not enter it on a tablet provided right there? Why should ordering at McDonalds be any different than getting money from a bank, or getting a boarding pass at an airport? High end restaurants answer this question by saying they think their customers value the personal attention of a waiter. Maybe, but certainly not at McDonalds.

The answer, for now, is certainly that it's cheaper the way it is. But not for long.. At the left is the first image that popped up when I googled "restaurant ordering app."

And McDonalds is also reportedly testing an ordering and cellphone payment app. "Currently being tested at locations in Salt Lake City and in Austin, Texas, the app lets users order a meal remotely then collect it in person from a store or drive-thru window." My server's job days are already numbered.

Looking more inquisitively behind the counter, it struck me that the technology overall has changed little since the 1960s when my parents took me there as a child. The fry-o-lator beeps,  a teenager picks the basket up and dumps it out, sprinkles salt, and uses a cute little piece of aluminum to neatly line them up in bags, just as they did back then. The main change I could see is that they annoyingly don't let you put your own sugar in your coffee any more.

It's clearly only a matter of time before this whole thing is automated.  Industrial robots can assemble cars; designing a robot to operate the fry-o-lator, or even to cook and assemble the whole hamburger doesn't look that hard. Mechanization usually increases quality: your burger and fries could easily be cooked to order. Swipe your phone or card to pay and off you go. Or, a little drone helicopter delivers it automatically to your table.

(Update: The machine is here already. And planning a new chain to use it, rather than sell to McDonalds, as predicted. Thanks to Michael Ward for pointing it out.)

Reflecting on it, though, it's unlikely to be McDonalds. McDonalds has an amazing technology when you look hard at it: They have figured out how to run restaurants in a way that dramatically conserves on the world's scarcest resource, human capital. To run a McDonalds, you don't have to know how to cook, how to order food, how to buy kitchen equipment, or all the other hundreds of bits of tough knowledge and skill that it takes to run a restaurant. Hamburger U trains the rest.

The whole operation is about taking low-skill teenagers living typically unstructured lives, and training them to what it takes to work.  Peering around the side of the cash register at an earlier trip, I noticed there were pictures on the buttons! You can work at McDonalds and operate its cash registers even if you're functionally illiterate! To say nothing of not knowing what to do when offered $10.12 to pay a $7.62 bill. And McDonalds has a big investment in that technology.

In the face of technical change, it is seldom the successful incumbents who adapt, even when they innovate. Kodak did not bring us digital cameras, trying to protect their film advantage. Print media did not bring us the internet, and are floundering at it. Walmart tries to go online, but Amazon.com is displacing it. The major airlines flop in every attempt to imitate Southwest.

So, as I gaze around the familiar golden arches, it strikes me that the automated fast food restaurant -- and the rapid decline in low-skill employment that it implies --  will likely not come from McDonalds itself. Rather, new competitors will arise that perfect the automated, people-less technology. In the same way that McDonalds displaced the previous era of fast-food restaurants, by perfecting a technology that brilliantly used lots of low-skill people and conserves on scarce human capital. For McDonalds to go automatic would be for it to throw away the key innovation that defines it and has made it such a success.

So we may be past the point that McDonalds sticks with 1950s technology because it's still cheaper to use people. We may just be waiting for the tipping point.

But robot repair technician is a high skill job. McDonalds provided a positive social externality -- it gave young people their first experience of work, of showing up on time, in a uniform, of learning to be pleasant to customers, to work within a heirarchical organization, and so on. Young people who work at McDonalds don't get internships at NPR, the New York Times, or Goldman Sachs to to develop work experience. As McDonalds goes, so will that process. All that will be left is cleaning.

A sturdy hike in the minimum wage, in today's economy, is basically an industrial policy subsidizing the transition to low-skill service industry automation.

A Chicago economist runs a central bank

Raghu Rajan celebrated his first day on the job running India's central bank. Coverage from Financial Times and Wall Street Journal.

Did he.. Find the coffee machine? Test the sofas in his office? Dust off his desk? Tour the printing press? Or...

Raghuram Rajan unveiled moves to liberalise banking and spread services across the nation of 1.3bn people... 

“There are so many low-hanging fruit in the economy that if we only pluck them we can accelerate growth substantially"...

The measures announced by Mr Rajan...are aimed at freeing India’s banks from the web of state controls that have stifled the sector since independence in 1947. ...

Indian banks will no longer have to receive RBI permission for each branch they want to open, though they will still be obliged to open branches in underserved rural areas in proportion to their expansion in the cities, Mr Rajan said....

He also suggested an easing of “priority sector lending requirements” that oblige banks to lend to farmers and small businesses, and said there was a need to reduce the requirement for banks to invest in government bonds so as to free credit for productive parts of the economy.

To say nothing of the wisdom of  forcing banks to buy shady sovereign debt, which turns sovereign troubles into banking crises, but he can't say that...

...foreign banks would be encouraged to operate in India as wholly owned subsidiaries that would enjoy “near national” treatment on a reciprocal basis.

“The Indian public would benefit from more competition between banks, and banks would benefit from more freedom in decision-making,” he said.

Competition a good thing in the financial sector? Heresy!

Other planned measures included the easing of restrictions on overseas borrowing by banks and on position-taking in financial markets, the introduction of new interest rate futures contracts, and the establishment of new mobile payments systems and “mini-ATMs” run by non-bank financial companies.

Indians who have traditionally turned to gold imports as a hedge against inflation will from the end of November be able to buy government savings certificates linked to a consumer price index, Mr Rajan said.

What will he do on his second day on the job? FT says he "will make his first substantial statement on monetary policy in two weeks." I'm looking forward to it.

Fed Chair

My pick for Fed chair below. I don't have much to say on the choice between Janet Yellen and Larry Summers. Both are worthy economists, with well-discussed pluses and minuses on which I have no particular insight.

So, this post is about who else one might want to look at, and much more importantly the broader question about what makes a good Fed chair.

The press mostly  wants a soothsayer, who will foresee events the market does not see and calm the waters -- in practice,  basically operating the worlds largest contrarian hedge fund, or the commissariat of macroeconomic central planning. Such people don't exist, so that's a self-defeating job description. Let's talk about reality.

The Fed chair will not just have to pick the right course, but will also have to wade through the cacophony of advice and pressure he or she will receive, from politicians, powerful banks and businesses, outside critics – people like me – and the crosswinds of contradictory advice from Fed board members, staff and regions. And then guide a headstrong committee and a ponderous bureaucracy to those ends.

To do that, a chair needs a clear intellectual framework and a core set of principles.

He or she must deeply understand modern macroeconomics, finance, and banking. Too many policy-oriented people are mired in simpleminded 1970-era Keynesian story-telling that they learned as undergraduates, and a similarly simplistic understanding of finance. Too many academic economists are too deep into modern work, take equations at face value and do not know how to distill and apply their essential lessons, and what lessons are robust from the inevitable simplifcations of all formal models. Too many bankers have little understanding at all of cause and effect. Long practical experience in a system produces little experience of how to guide that system.

The FOMC (Federal Open Market Committee) of bank presidents and governors is now as high-powered a group as you could imagine. The academics have taken over. They know their stuff, and so does their staff. When the staff brings in or a governor cites “unique locally bounded equilibria” of the latest "new-Keynesian DSGE model," or distills the tea leaves of interest rates in “three factor affine models,” a chair must find the nuggets of gold, the grains of salt, and the remains of horses. All three are present.

There is a tendency in many quarters, reflected well in the New York Times opinion pages, to dismiss modern macro as hogwash. (Except, of course, when particular equilibria of particular new-Keynesian models produce pleasing multipliers.) Dismissing all modern thinking is as dangerous as accepting it all uncritically. If for no other reason, this is the language the FOMC and its staff speak, so a chair who doesn't understand it will simply be bamboozled.

We are at a crossroads in monetary policy,  with deeply different intellectual frameworks bounding the discussion, from monetarists, old-fashioned IS-LM Keynesians, Minnesota/Chicago dynamic equilibrium, new-Keynesian DSGE all talking past each other in essentially different languages. And I haven't started on financial views, even more disparate. The chair must be literate! And this stuff is hard. Well, I think it's hard. It's going to be hard to find someone who has not been actively contributing to this thinking who really understands what's going on.

An ideal chair has the universal admiration and respect of all in the room -- they may disagree, but everyone knows the chair deeply understands all the modeling points of view. An ideal chair also has the rare talent to explain and apply modern macroeconomics, not just push the equations around correctly.

More deeply, the fundamentals of modern macro -- thinking intertemporally, thinking about expectations, rules, institutions, moral hazards, precommitment vs. discretion, not in static terms of this year's stimulus and this year's GDP, really are important guides to a successful central bank.

That intellectual framework should be broad as well as deep. Some people have one great idea and to Washington to  implement their pet idea. Such people do not often do well when asked to guide a large institution through, inevitably, uncharted waters. Great military theorists do not make great battlefield generals.

A great Fed chair also understands history, and the legal and institutional structure of the Federal Reserve and previous central banks. Too many academics, (I include myself, though I'm trying to repair the damage)  are steeped in theory and quantitative evidence, but pretty light on the simple facts of what happened in past crises.

Nobody can know everything, however, so the Fed chair needs a few core principles. Paul Volcker had them, when the cacophony of experts said we couldn’t stop inflation. Ronald Reagan had them, when he said “tear down this wall” over the cacophony of experts. And those principles need to be right.

So, a great Fed chair is not so much smart as wise. There is a big difference. Humility is a bedrock of wisdom. The chair needs clearly to understand the limits of our knowledge, how imperfectly we understand cause and effect of the Fed’s policy tools.  A wise chair remembers how much consensus views on those matters have changed in the past, and knows how much they will change in the future.  If the Chair does a good job, ideas will change in response to the slow accumulation of experience and not in the wake of some new disaster borne of overconfidence in wrong ideas.

Above all, a successful chair will avoid screwing up! The Fed is a defensive institution. Like oil in the car, you don't notice it when it's doing its job well, and it mainly is in the news when it fails. It is not an institution that succeeds by leading great charges to direct the economy.

The big past screwups came when old ideas met new events, as they did in the banking crises of the great depression and the unleashing of the great inflation of the 1970s, just as on the 1914 western front and Maginot line.

An ideal chair has thought a lot about issues which are likely to be the next great crisis. Ben Bernanke was one of the great scholars of the bank runs of the Great Depression, and in part as a result the Fed did not repeat many of the mistakes of that event.

But we never fight the last war, at least right away. The chance of us having another real estate boom, a huge increase in shadow banking, a run in short term debt linked to mortgages in the next 10 years is next to zero.  So what are the challenges going forward, and what special expertise would one want in a Fed chair?

It seems obvious to me that sovereign debt, sovereign promises, an emerging period of sclerotic growth (rather than "lack of demand" recession) and how monetary policy is fundamentally affected by this set of circumstances is going to be a big issue for the Fed going forward. A chair who relies only on rules of thumb or correlations that held in a time of high trend growth and small sovereign debts is going to be taken by surprise.

An ideal Fed chair has spent a lot of time thinking about, and surveying the wide historical and cross-country experience on, the link between monetary policy, sovereign finances, and large-scale economic fluctuations. When California and Illinois default, Spain can't roll its debts, Germany refuses to recapitalize the ECB, and US long rates spike, a chair armed only with shifting around IS and LM curves and bailing out creditors will fall flat.

It also seems obvious to me that financial regulation, the temptations to financial micromanagement, and the forces of capture by the financial industry, are going to fill the Fed's plate as much or more than the mundane question of whether to raise or lower short term interest rates by a few basis points.

Financial regulation is even more about moral hazard, rules, institutions and perceptions than regular monetary policy. Chair William McChesney Martin, referring to rising interest rates, once sad the job of the Federal Reserve was to take away the punch bowl just as the party gets going. Now that the Fed is managing "financial stability,"  the chair’s job is to more to stop putting out fires soon enough that the underbrush burns out, people don’t build their houses too close to trees, and keep their own fire extinguishers loaded. At some point, you  let Bear Stearns go to send a message to Lehman Brothers.  A Fed chair that spends a lot of his time clarifying what the Fed's role will be in the next crisis rather than one who just ammasses larger and larger discretionary power, will weather that crisis much better.

Resisting capture will be a full time job. When billions of dollars are on the line for powerful Wall Street firms, the chair needs to be someone who can say no -- and who everyone knows will say no. From before the Fed’s inception, people have wanted to manipulate monetary policy and financial regulation to their ends.  They will steer subsidies and protection their way, they will use regulation to block competition, and they will steer credit their way.

We didn't have a central bank for a century, mostly because of this fear. The argument over having a central bank at all focused on the concentration of financial power and its marriage to political power, not inflation and unemployment. Now that the Fed is squarely running the financial system, and not just setting interest rates, we will start that discussion again.

Ideally it would not matter at all who the Fed chair is. Our government works well when the institutions work, not when we await the right benevolent aristocrat to run things with great power and no accountability. So a wise central banker is not one in the news every day, spouting a frenzy of new ideas. The wise central banker works within and buttresses well codified rules of behavior, thinks hard about what those rules should be, and slowly moves them over time.

Oh, and politics matter. Pick a Democrat.

So who fills that bill? I've pretty much described Tom Sargent. If you want a taste, go to his website. His latest paper "Fiscal discrimination in three wars" with George Hall is just what I would want a Fed Chair to be thinking about with state and local defaults looming. His Nobel Prize speech "US Then, Europe now" is one of the wisest set of thoughts on the Euro crisis I've seen. Some of my favorite classics: "The macroeconomics of the French Revolution" with Francois Velde. There you see how Tom can put modern macro into action, to understand real-world events. Of course his studies of the fiscal roots of hyperinflations are fundamental. He knows macroeconomic theory of all stripes inside and out. He knows the history and institutions inside and out.  He is one guy who could command hushed awe in the FOMC.

There are a few other candidates who fit the bill similarly. I don't want to get too deep in to personalities, it's the job posting that counts. You could make a similar case for, among others Ken Rogoff, David Romer, John Taylor, Mike Woodford, Greg Mankiw, and many others. (Just examples; I don't mean to insult anyone by omission). The interesting observation is that none of these are on the agenda reported in the papers.

There is perhaps two good reasons why such candidates are not on the table. First,  the Fed chair runs a large organization. The talents of corralling a bureaucracy, herding the opinionated cats on the board of governors, keeping the staff in line, working within the legal and institutional structure of the Fed, keeping one’s mouth shut so as not to roil markets and cause scandals, (or perhaps talking so much that markets stop paying attention? That's what would happen if I were Fed chair!) while furthering the Fed’s admirable quest of transparency are crucial.

Second, the chair has to make hard decisions in real time. This is incredibly hard.

Most academics don't have these skills. I don't know if Tom does. Perhaps some trial of running a large organization is a needed requirement.

And of course, the chair needs to persuade one person he or she will be good at the job, the president. Ben Bernanke served on George Bush's council of economic advisers, and undoubtedly impressed Bush. Tom impresses me, but I'm not in charge.

You may object that I'm thinking too narrowly. I'm a university academic, so I'm pushing other university academics. But in this case, I think that's warranted. The academics really have thought long and hard about central banking, and they have taken over from the bankers. The FOMC is a great debating club of monetary and financial policy. An industry economist or banker will get eaten alive.

By the way, I think when the dust has settled, history will be kind to Ben Bernanke. He fits most of my job description. Inflation is stuck at 2%, the world did not melt down, and we’re all gradually coming to the realization that if $2 trillion bucks of stimulus and zero interest rates didn’t bring our economy out of the doldrums, there really is nothing more that a central bank could do. The Phillips curve has been screaming "this is supply, not demand" for a few years now. Like any great general, we can argue with specific decisions, and much of the direction of Fed policy, and I have. But we have not lost the war.

Yet. The next chair could easily make Mr. Bernanke’s term look even better.

Nasdaq freeze

An anonymous correspondent explained last week's Nasdaq freeze thus.

The truth about what happened Aug 22 to the Nasdaq is that new limit-up/limit-down rules took effect in derivatives (exchange-traded products) listed at Arca at the same time that new options began trading marketwide that day. Since the market is full of complex, multi-leg trades, bad data propagated, affecting Goldman’s options-trading algorithms Tuesday, spawning hundreds of derivatives trading halts by VIX expirations Wednesday, and producing bad data in the consolidated tape by Thur, halting Nasdaq trading. So the real culprit was the SEC. But it’s bad form to say publicly that the regulator is responsible for jeopardizing the market.

I can't vouch for the story, or even for understanding it all. But I'm interested in several emerging stories that some trading pathologies are in part unintended consequences of SEC regulation. It's also not the first time I hear of financial market participants afraid to speak out and earn the disfavor of their regulator.

Macro-prudential policy

Source: Wall Street Journal

Not a fan. A Wall Street Journal Op-Ed. Link to WSJ. Link to pdf on my website. Director's cut follows:

Interest rates make the headlines, but the Federal Reserve's most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a "macroprudential" policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.

For example, the Fed is urged to spot developing "bubbles," "speculative excesses" and "overheated" markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by "restraining financial institutions from excessively extending credit." How? "Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting."

This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm's managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm's customers are contributing to booms or busts the Fed disapproves of.

Macroprudential policy explicitly mixes the Fed's macroeconomic and financial stability roles. Interest-rate policy will be used to manipulate a broad array of asset prices, and financial regulation will be used to stimulate or cool the economy.

Foreign central banks are at it already, and a growing consensus among international policy types has left the Fed's relatively muted discussions behind. The sweeping agenda laid out in "Macroprudential Policy: An Organizing Framework," a March 2011 International Monetary Fund paper, is a case in point.

"The monitoring of systemic risks by macroprudential policy should be comprehensive," the IMF paper explains. "It should cover all potential sources of such risk no matter where they reside." Chillingly, policy "should be able to encompass all important providers of credit, liquidity, and maturity transformation regardless of their legal form, as well as individual systemically important institutions and financial market infrastructures."

What could possibly go wrong?

It's easy enough to point out that central banks don't have a great track record of diagnosing what they later considered "bubbles" and "systemic" risks. The Fed didn't act on the tech bubble of the 1990s or the real-estate bubble of the last decade. European bank regulators didn't notice that sovereign debts might pose a problem. Also, during the housing boom, regulators pressured banks to lend in depressed areas and to less creditworthy customers. That didn't pan out so well.

More deeply, the hard-won lessons of monetary policy apply with even greater force to the "macroprudential" project.

First lesson: Humility. Fine-tuning a poorly understood system goes quickly awry. The science of "bubble" management is, so far, imaginary.

Consider the idea that low interest rates spark asset-price "bubbles." Standard economics denies this connection; the level of interest rates and risk premiums are separate phenomena. Historically, risk premiums have been high in recessions, when interest rates have been low.

One needs to imagine a litany of "frictions," induced by institutional imperfections or current regulations, to connect the two. Fed Governor Jeremy Stein gave a thoughtful speech in February about how such frictions might work, but admitting our lack of real knowledge deeper than academic cocktail-party speculation.

Based on this much understanding, is the Fed ready to manage bubbles by varying interest rates? Mr. Stein thinks so, arguing that "in an environment of significant uncertainty . . . standards of evidence should be calibrated accordingly," i.e., down. The Fed, he says, "should not wait for "decisive proof of market overheating." He wants "greater overlap in the goals of monetary policy and regulation." The history of fine-tuning disagrees. And once the Fed understands market imperfections, perhaps it should work to remove them, not exploit them for price manipulation.

Second lesson: Follow rules. Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day. The economy does not react mechanically to policy but feeds on expectations and moral hazards. The Fed sneezed that bond buying might not last forever and markets swooned. As it comes to examine every market and targets every single asset price, the Fed can induce wild instability as markets guess the next anti-bubble decree.

Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.

How will home builders react if the Fed decides their investments are bubbly and restricts their credit? How will bankers who followed all the rules feel when the Fed decrees their actions a "systemic" threat? How will financial entrepreneurs in the shadow banking system, peer-to-peer lending innovators, etc., feel when the Fed quashes their efforts to compete with banks?

Will not all of these people call their lobbyists, congressmen and administration contacts, and demand change? Will not people who profit from Fed interventions do the same? Willy-nilly financial dirigisme will inevitably lead to politicization, cronyism, a sclerotic, uncompetitive financial system and political oversight. Meanwhile, increasing moral hazard and a greater conflagration are sure to follow when the Fed misdiagnoses the next crisis.

The U.S. experienced a financial crisis just a few years ago. Doesn't the country need the Fed to stop another one? Yes, but not this way. Instead, we need a robust financial system that can tolerate "bubbles" without causing "systemic" crises. Sharply limiting run-prone, short-term debt is a much easier project than defining, diagnosing and stopping "bubbles." [For more, see this previous post] That project is a hopeless quest, dripping with the unanticipated consequences of all grandiose planning schemes.

In the current debate over who will be the next Fed chair, we should not look for a soothsayer who will clairvoyantly spot trouble brewing, and then direct the tiniest details of financial flows. Rather, we need a human who can foresee the future no better than you and I, who will build a robust financial system as a regulator with predictable and limited powers.

*****
Bonus extras. A few of many delicious paragraphs cut for space.

Do not count on the Fed to voluntarily limit its bubble-popping, crisis management, or regulator discretion. Vast new powers come at an institutionally convenient moment. It’s increasingly obvious how powerless conventional monetary policy is. Four and a half percent of the population stopped working between 2008 and 2010, and the ratio has not budged since. GDP fell seven and a half percent below “potential,” in 2009 and is still six points below. Two trillion didn’t dent the thing, and surely another two wouldn’t make a difference either. How delicious, in the name of “systemic stability,” to just step in and tell the darn banks what to do, and be important again!

Ben Bernanke on macroprudential policy:

For example, a traditional microprudential examination might find that an individual financial institution is relying heavily on short-term wholesale funding, which may or may not induce a supervisory response. The implications of that finding for the stability of the broader system, however, cannot be determined without knowing what is happening outside that particular firm. Are other, similar financial firms also highly reliant on short-term funding? If so, are the sources of short-term funding heavily concentrated? Is the market for short-term funding likely to be stable in a period of high uncertainty, or is it vulnerable to runs? If short-term funding were suddenly to become unavailable, how would the borrowing firms react--for example, would they be forced into a fire sale of assets, which itself could be destabilizing, or would they cease to provide funding or critical services for other financial actors? Finally, what implications would these developments have for the broader economy? ...

As if in our lifetimes anyone will have precise answers to questions like these. In case you didn't get the warning,

... And the remedies that might emerge from such an analysis could well be more far-reaching and more structural in nature than simply requiring a few firms to modify their funding patterns.

A big thank you to my editor at WSJ, Howard Dickman, who did more than the usual pruning of prose and asking tough questions.