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.

Immigration

WSJ Op-Ed on immigration, with extra comments.  Original here.

Think Government Is Intrusive Now? Wait Until E-Verify Kicks In

Source: Wall Street Journal

Massive border security and E-Verify are central provisions of the Senate immigration bill, and they are supported by many in the House. Both provisions signal how wrong-headed much of the immigration-reform effort has become.

E-Verify is the real monster. If this part of the bill passes, all employers will be forced to use the government-run, Web-based system that checks potential employees' immigration status. That means, every American will have to obtain the federal government's prior approval in order to earn a living.


E-Verify might seem harmless now, but missions always creep and bureaucracies expand. Suppose that someone convicted of viewing child pornography is found teaching. There's a media hoopla. The government has this pre-employment check system. Surely we should link E-Verify to the criminal records of pedophiles? And why not all criminal records? We don't want alcoholic airline pilots, disbarred doctors, fraudster bankers and so on sneaking through.

Next, E-Verify will be attractive as a way to enforce hundreds of other employment laws and regulations. In the age of big data, the government can easily E-Verify age, union membership, education, employment history, and whether you've paid income taxes and signed up for health insurance.

The members of licensed occupations will love such low-cost enforcement of their cartels: We can't let unlicensed manicurists prey on unsuspecting customers, can we? E-Verify them! And while the government screens employee applications, they can also check on employers' compliance with all sorts of regulations by looking at the job applications they submit for verification.

E-Verify proponents imagine some world in which a super-accurate government database tracks each person's legal status, and automatically enforces straightforward rules. Maybe on Mars. In our world, immigration and employment law is a complex mess, and our government's website-building capacity (see under: "health-insurance exchanges") can't possibly handle millions of people who are trying to evade the law. Permission to work inevitably will rely at least in part on the judgment calls of an army of bureaucrats.

Political abuse is just as inevitable. Consider Catherine Engelbrecht, reportedly harassed by the Federal Bureau of Investigation, the Internal Revenue Service, the Bureau of Alcohol Tobacco and Firearms and the Occupational Safety and Health Administration, all for starting a tea-party group. But the E-Verify bureaucrats would never cause her trouble in getting a job or hiring someone, right?

Soon, attending a meeting of a group that is a bit too enthusiastic about the Constitution or gun rights—or being arrested at an Occupy Wall Street rally—could well set off a "check this person" when he applies for a job. If the government can stop you from working, how can you be free to speak out in opposition?

It's the need for prior permission rather than ex-post prosecution that makes E-Verify so dangerous. A simple delay in processing or resolving an "error" in your data is just as effective as outright denial, cheap to do, and easy to cover up.

Every tyranny silences opponents by controlling their ability to earn a living. How is it that so many supposedly freedom-loving, small-government Republicans want to arm our nation's politicized bureaucracy—fresh from the scandals at the IRS and elsewhere—with the power to do just that? Why are we so afraid of immigrants that we would jeopardize this most basic guarantee of our political liberties?

Many opponents of immigration worry that immigrants will overuse expensive social services. The fear is misplaced. The Congressional Budget Office estimates more than $100 billion of net fiscal benefit from the limited expansion of immigration that's allowed by the Senate bill. And this fear does not make any sense of the system's preferences for current citizens' family members—who are less likely to work and more likely to consume services—over workers and entrepreneurs.

Perhaps some Republicans worry that immigrants will vote Democratic. But then limiting entrepreneurs and workers makes even less sense. These Republicans should have confidence that their ideas on freedom will attract ambitious, hard-working migrants.

Others say they want to protect the wages of American workers. Like all protectionism, that is demonstrably ineffective. Migrants come for jobs Americans won't or can't do, and businesses build factories abroad if workers can't come here.

The Senate bill promises higher caps for "guest workers." Ponder what "guest worker" really means. Come to America, pick our vegetables, clean our bathrooms and tend our gardens at the invitation of a powerful employer. Pay taxes. And when your visa runs out, go back where you came from—there is no place for you here. This is how Middle East sheikdoms treat Filipino maids and Palestinian construction workers. Is this America?

In the current vision of immigration reform, millions will still be trying to sneak in, and millions more will remain here working illegally. E-Verify and the border security wall prove it. If people could work legally, there would be no need for a system that endangers everyone's liberty to "verify" them. And there would be no need to build a $45-billion monument to imperial decline— our bid to outdo the walls of Hadrian, China and Berlin—to stop them. [Only the ruins won't be pretty enough to attract Chinese tourists a few centuries from now.]

Here is the crucial question for genuine immigration reform: How do we respond when someone says, I have heard of your freedom. I am tired of the corrupt police in my country, the bought-off courts, the oppression of rulers, the tyranny of the religious or ethnic majority. I want to join the one country on earth defined by an idea, not by conquest, religion or ethnic identity. No, I don't have a special skill or a strong back useful to your politically connected employers. I want to come, drive a cab, open a convenience store in a poor neighborhood, work long hours, pay taxes, send my children to school and, eventually, vote.

The answer in the Senate bill and emerging House debate remains: Stay home. America is closed. [The question is, why?]

**************************

A few more comments.

Boiled down to one sentence, where this all started. Grumpy reads the news. Reaction: "You guys want every American to have to ask the permission of the Federal Government in order to get a job??? Have you lost your minds? How many founding fathers are rolling over in their graves?"

Space is at a premium in an oped so a lot of fun stuff got cut including the few [] above.

I know there is a serious empirical literature on how much immigrants do or don't affect wages here, and whose wages. Also, I said jobs that Americans "can't or won't do," and any economist should always ask "at what wages."  I had one sentence, so give me a break. (Though, from what I've read, the wages it would take to get Americans to work at a poultry processing plant or pick fruits and vegetables would imply pretty astronomical price increases - or wholesale movements of those industries abroad.)

But... If it raises the welfare of Texans to keep out workers from old Mexico, why does it not make sense for them to keep out workers from New Mexico? National borders have no meaning in economics.

And even if it did work, it would merely be a pure transfer, a zero-sum game. If we want to subsidize wages of some Americans, do we really to tax the wages of poor Mexicans to do it?  Is this America's place in the world, to engineer transfers form poor Mexican migrants to our workers? The tax also shows up on the prices Americans pay, often the same Americans whose wages we're trying to subsidize. A most basic principle of economics is: don't engineer wealth transfers by distorting prices. If you can understand that for ethanol, you can understand that for labor.

The one-sentence shot about moving factories abroad is serious. The studies showing some benefit from keeping out foreign workers typically document short-run effects.  We've been keeping out foreigners for two generations now, and it doesn't seem to have helped the wages of workers who compete with foreigners a lot! People also choose which occupations to enter.

I didn't have room to talk about the 11 million already here. One decent thing in the Senate bill is to recognize that we can't go on like this with 11 million people relegated to second-class status. However, making them wait another 13 years before they can become citizens... Didn't we once have a revolution about "taxation without representation?"

The "guest" worker visas only allow them to work in "qualified" industries and for limited amounts of time. That means e-verify is already set up to check that you're allowed to work in specific industries, and for specific time periods, not the simple in or out you might imagine.

"Soon, attending a meeting of a group that is a bit too enthusiastic about the Constitution or gun rights—or being arrested at an Occupy Wall Street rally—could well set off a "check this person" when he applies for a job" Besides the grammar getting a bit mangled in the edits, we lost sight of just how plausible this is. Of course "terrorists" shouldn't be allowed to work in the US, right? How many congresspeople would vote against a bill adding "potential terrorists and national security threats" to the e-verify system?  But of course bureacracies' idea of "terrorist" and yours and mine might be a bit different. Mark Steyn (a favorite of mine) is illuminating here

The other day, The Boston Globe ran a story on how the city's police and other agencies had spent months planning a big training exercise for last weekend involving terrorists planting bombs hidden in backpacks left downtown. Unfortunately, the Marathon bombers preempted them, and turned the coppers' hypothetical scenario into bloody reality. What a freaky coincidence, eh? But it's the differences between the simulation and the actual event that are revealing. In humdrum reality, the Boston bombers were Chechen Muslim brothers with ties to incendiary imams and jihadist groups in Dagestan. In the far more exciting Boston Police fantasy, the bombers were a group of right-wing militia men called "Free America Citizens," a name so suspicious (involving as it does the words "free," "America," and "citizens") that it can only have been leaked to them by the IRS. What fun the law enforcement community in Massachusetts had embroidering their hypothetical scenario: The "Free America Citizens" terrorists even had their own little logo – a skull's head with an Uncle Sam hat. Ooh, scary! The Boston PD graphics department certainly knocked themselves out on that.

Do you really want people like this deciding who can work -- and in what industries -- in America? The e-verify system is already connected to homeland security!

The opposite is just as worrisome. The big data miners at the NSA and homeland security will surely be interested to monitor every time a "suspected terrorist" applies for a job, no?

I had a lot more examples of past political persecution in this country.  Historically the left has been persecuted by the government a lot more than the right. The FBI harassed civil rights leaders. Remember the red scare, and the blacklist. Good thing we didn't have e-verify back then.

Henry Miller (also Hoover) had a lovely NRO post on Thursday with detailed accounts of politicized discretion at work in Federal Agencies. Read this and think about how e-verify will work.

The worry that Federal control of employment will  misused is not a new thought. See chapter 1 of Milton Friedman "Capitalism and freedom."

An economic e-verify consequence I didn't have space for: expansion of the underground economy. There will still be millions of people here trying to work illegally. If not, what's the point of e-verify? Many of the 11 million here who won't qualify for the rather strict program to stay, and the slightly looser caps will still leave many shut out.

OK, so there's this much more effective e-verify, you need a job, and your employer needs a worker. What do you do? Answer: go fully illegal. The current system, in which illegal (or maybe I should use the new word "unauthorized." I like that one!) workers can get fake social security numbers and continue semi-legally, paying taxes, paying social security and medicare (on which they will never collect), and enjoying some legal protection, goes down the toilet. Now it's cash under the table.

And once employers get used to cash under the table, why stop with the immigrants? Benefits, health care, taxes, red tape, unions, NLRB, OSHA, it's all getting to be such a pain. Why not pay the Americans cash under the table too?

It's one more step to a two-tier economy, like much of southern Europe. There are a few "good" full time legal jobs with benefits, pensions, etc. And a vast amount of black-market work. Especially for young people, recent migrants (authorized or unauthorized), minorities, and so on.  Even a true-blue libertarian wants work to operate with protections afforded by the legal system -- enforceable contracts and all that. And anyone with a vague soft spot for labor laws including safety, health, worker rights and so on, ought to worry about the consequences of expanding completely illegal labor.

Just because you pass laws against things doesn't mean they stop.

Oh those looser caps. A bureaucracy has to certify that economic conditions are strong enough before more people get let in. The lobbying on that one will be fun to see. Maybe they can import some retired Fed governors. My forecast: labor markets will be strong enough to admit immigrants when there is no American voter who wants a better job, i.e. when hell freezes over.

For a half century, we decried that the Soviet Union controlled who could work where, and ruining the lives of dissenters. We decried that they posted soldiers at the border with guns to stop people from leaving. "Mr. Gorbachev, tear down this wall!" Do we really want to set up the system that allows the former. And does it really matter which side of the border has the soldiers with guns? Certainly to the people trying to pass, it matters not one bit.

Thanks without blame to Tom Church at Hoover for a lot of help on facts.

If you're still reading, here's an earlier post with more

Update

Richard Sobel has a nice piece making an important point that I totally missed. E-verify will have to mean a national, biometric identity card. Now, you submit a social security number. What stops people from submitting false names and social security numbers? Hmm need to make sure they are who they say they are...

I also didn't think to point out another danger. Now the Federal government and its Big Data base know every time you apply for a job. Hmm, why is that guy Cochrane applying for a job again? Checking how often you apply for a job will naturally be an important way to check against false social security numbers.

Alternative Maximum Tax

This is an Op-Ed for the Wall Street Journal, original here on April 15 2013

Source: Wall Street Jouirnal

They keep coming back, like the villains of a good zombie movie, chanting "more taxes, more taxes." Long ago, Congress passed the alternative minimum tax, or AMT—a simple flat rate to ensure that in an insanely complex tax code, no one escapes paying something. Now we need an alternative maximum tax as a simple, rough-and-ready way to limit the tax zombies' economic damage. Call it the AMaxT.

With Monday's deadline for filing tax returns looming, let's start a national conversation: How much is the most anyone should have to pay? When do taxes indisputably start to harm the economy and produce less revenue—when government takes 50% of people's income? 60%? 70%?

I like half, but the principle matters more than the number. Once the country settles on a number, each of us gets to add up everything we pay to government at every level: federal income taxes, yes, but also payroll (Social Security, Medicare, etc.) taxes, state, city and county taxes, estate taxes, property taxes, sales taxes, payroll taxes and unemployment insurance for nannies, household workers, or other employees, excise taxes, real-estate transfer taxes, and so on and on, right down to your vehicle stickers and those annoying extra taxes on your airline tickets.

On April 15, once this total hits the alternative maximum tax, you've done your bit and federal income taxes can take no more. You compute federal income taxes as usual, but then you get to reduce the "tax due" that the total is less than the alternative maximum.


The zombies howl that the top federal tax bracket is still "only" 40%. Surely "the rich" can contribute a bit more? They forget that the economic damage of taxes comes from the total tax bite, not just the federal income tax.

Marginal taxes are a purer measure of economic damage. If you earn one more dollar, how much do you get to keep? Marginal rates are higher than average rates in a progressive system: If the government takes 100% of income above $100,000, then somebody earning $150,000 pays a 33% average tax rate but has no incentive to work at all after he reaches $100,000. Ideally, we would limit marginal rates, but this is not practical in a simple backstop like the AMaxT.

American governments also like to hide taxing and spending by passing mandates and regulations, forcing people and businesses to spend on their behalf. Ideally, we would limit this economic damage as well, but this is also not practical in an alternative maximum tax.

However, both considerations mean that the true economic damage will be higher than the AMaxT rate, so we should leave some headroom in setting that rate.

Every cent of corporate taxes comes out of some person's pocket, in higher prices, lower wages, or lower returns to investors. For example, even the tax zombies don't dream that we stick it to the big oil companies by charging gas taxes. To limit this damage, every single cent of tax that government assesses, at all levels, should be assigned to somebody and count against that person's alternative maximum tax. It is easiest to assign all corporate taxes to shareholders. When corporations send you the annual 1099 dividend form, they also report all taxes paid by your shares, which count against your AMaxT. Some taxes could similarly be assigned to workers and reported on W2 forms.

Yes, there are details to work out. People get big tax bills in some years, such as when they pay estate taxes. Incomes fluctuate. Smart tax lawyers could game the system.

This isn't hard to fix. For example, we could use an average of several years' income or, better yet, scale the AMaxT limit to consumption rather than income.

Liberals might object to a maximum tax, since it leaves out all the benefits that we get from government. In setting the maximum level of taxation, shouldn't we consider the nice roads, free schooling, police, national defense, thoughtful regulation, and other benefits and services?

This is a valid consideration if one argues about what's "fair." But I propose the AMaxT entirely to limit the economic damage of taxation, a goal you must consider even if you think it's "fair" to take every cent of a rich person's income.

To limit economic damage, benefits are irrelevant. Suppose that the government levies a 100% income tax, but it is so good at providing services that each of us gets back twice the value of what we put in. Good deal? Yes. Functioning economy? No. Each person gets services whether they do or don't pay taxes. But with a 100% income tax, nobody works, nobody pays any taxes, and nobody actually gets any services.

How many people are really being taxed at outrageous rates? I don't know. The U.S. tax system is so complex, with so many layers of taxing authority, that nobody really knows. Still, an alternative maximum tax is a win-win bet.

If there really are few people who pay an extraordinarily high percentage of their income, then liberals shouldn't object. They won't lose any revenue and will enjoy snickering "I told you so." If it turns out that there are lots of people being so taxed, then we will sharply reduce the unintended, multiplicative effect of taxation, and we will measure that fact. A canary in the coal mine is as valuable chirping as choking.

The disincentive effects of heavy taxation settle in gradually. For the first year or two, all people can do is hire smarter lawyers and work a little less hard. It takes years for businesses to retrench, close, never get started or fail to expand; for people and companies to move abroad; for students to give up investing in an expensive M.B.A., medical school or engineering degree; for people to stay put rather than follow lucrative opportunities, or to retire early. All this shows up slowly and gradually drags down an economy and its tax revenues.

So the AMaxT is most important for the backstop promise it makes to young people and entrepreneurs. Yes, start a company, go to school, work hard, invest, hire people. We guarantee you that no matter what happens, no matter how loud the zombies chant, no matter what clever "revenue enhancers" they come up with, you will get to keep some reasonable fraction of what you earn. Go for it.

( One more point that got cut for length: With an alternative maximum tax, people might abandon complex tax dodges in favor of simply taking the alternative maximum.)

Updates: Several people have pointed out that this system advantages states with high income taxes. Good point. Since state and federal income taxes are both due April 15, let's amend the proposal to let you cut back proportionally on both federal and state income taxes. Oh, and credits against next year too.

A colleague writes: Perhaps you know this, (I didn't) but the corporate system you describe is close to the franking credits used in Australia, New Zealand, Malta and maybe other countries. In essence, rather than declare the dividends they receive on their income taxes, shareholders report the corporation’s before-tax earnings that supported the dividends (the grossed-up dividend) and include the taxes the corporation paid as a credit against their taxes. For your purposes, this system already assigns the corporate taxes to the shareholders. (If your tax rate is 0, you actually get a check back from the government for the amount of taxes the corporation paid on your behalf.)

On the issue, how many people are there who pay more than half. Total, on budget, federal state and local spending is about 42% of GDP. Tax expenditures bring that up to 46%. Off budget, mandates, etc. bring us easily over 50%. The average person is already paying something like his income in taxes, either now or later (when the debt comes due). Europe's numbers only look bigger because they collect it all in one place.

Allen Sanderson has a nice related Op-Ed adding up some state and local taxes in Illinois

CBO and fiscal cliff, again

I turned last week's CBO post into an Op-Ed for Bloomberg. This version is better.

Last month, the Congressional Budget Office released a report warning that the “fiscal cliff” would cause a new recession. It came to the right conclusion for all the wrong reasons.

Reasons matter. A policy response crafted to satisfy the CBO’s analysis would hurt the economy. Reports such as this one would be much more useful if the agencies that publish them were more transparent about the calculations, and explained the logic of their models.

This is the cliff: Unless Congress acts, the Bush-era income-tax cuts will expire, Social Security payroll taxes will increase, and capital-gains and dividend tax rates will rise sharply. Also, the estate tax will come back with a roar, “mandatory” spending cuts will take effect, the extension of unemployment insurance to 99 weeks will expire, and Medicare payment rates to physicians are supposed to be slashed.

The CBO projects that “such fiscal tightening will lead to economic conditions in 2013 that will probably be considered a recession, with real GDP declining by 0.5 percent between the fourth quarter of 2012 and the fourth quarter of 2013 and the unemployment rate rising to about 9 percent in the second half of calendar year 2013.”

Keynesian Projections

How does the CBO come up with these numbers? Its projections are Keynesian. If the government borrows $1 billion and spends it, the CBO will project that this action raises gross domestic product by $1.5 billion. Government workers are counted as “producing” what they cost, so borrowing money to keep them employed generates the same GDP as building a bridge. If the government just gives the money to people, this also raises the CBO’s GDP estimate. Reducing government spending and transfers has the opposite effect.

If, like me, you think that spending less money on useless projects is good for the economy, or that taking money from A and giving it to B has little overall effect, you would come to much different conclusions from the CBO’s.

Similarly, the CBO says raising tax rates hurts the economy because taxpayers will consume less, lowering “aggregate demand.” If, like me, you think that taxes hurt the economy not so much because of how much people have to pay rather than lend to the government, but because higher (marginal) rates discourage work, saving, investment, business formation and growth, then the CBO’s numbers are meaningless to you.

The central distinction between Keynesian and regular economics is the assumption that people don’t respond to incentives. In regular economics, prices and taxes first and foremost change incentives. Transfers, though important to the people who pay and get them, have much smaller effects on the overall economy. Keynesian economics and the CBO’s analysis take the opposite view: Transfers matter, incentives don’t.

A good example: What will be the effect of curtailing 99 weeks of unemployment insurance? To the CBO, it will reduce GDP because would-be beneficiaries will consume less. A standard economic analysis predicts that it will have the opposite effect, increasing GDP and bringing down unemployment. That’s because unemployment insurance means some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move.

(Remember that the CBO and I aren’t opining on what’s good or bad. The point is only to project whether GDP and unemployment will go up or down. Some unemployment insurance can be a good thing even though it hurts GDP and raises unemployment.)

Tax Increases

To the CBO, tax increases and spending cuts have about the same effect. In my analysis, higher tax rates are more damaging than spending cuts. To me, a revenue-neutral tax reform that took in the same amount of money at much lower marginal rates would be a boon. It would have little effect at all in the CBO’s analysis.

In my view, the bigger problem with the fiscal cliff is the utter chaos it reflects. What serious country decides its tax laws year by year, in one big crisis during the first few weeks of the year? The CBO’s model doesn’t assess chaos.

Moreover, this crisis atmosphere is a fiesta for lobbyists, tax lawyers and crony capitalists of all stripes. The CBO’s list of expiring tax provisions gives a taste:

“Cellulosic Biofuel Credit, Credit for Past Minimum Tax Liability, Depreciation of Certain Ethanol Plant Property, Election to Accelerate AMT and R&E Credits in Lieu of Electricity Production Credit for Wind Facilities, Exclusion of Mortgage Debt Forgiveness, Indian Coal Production Credit....”

The list goes on. Lobbyists will fight for each one in the middle of the night.

So, in my view, most of the CBO’s analysis is wrong.

This matters most as we consider alternative policies. CBO- style analysis will encourage more ineffective “stimulus” spending. It won’t lead to the all-important tax reform that stabilizes and simplifies the code and lowers marginal rates. It won’t help reduce the vast amount of useless government spending.

(To the CBO’s credit, it has been warning that skyrocketing debt poses a long-run threat. But higher long-term interest rates seem a distant worry to a still-struggling economy.)

Its analysis isn’t logically wrong. If you accept its Keynesian logic and the absence of incentive effects, the CBO’s assessment makes sense. It’s those ifs that are wrong.

The deeper problem is that we really don’t know how the CBO gets its numbers. You can search its website without finding a reproducible description of the calculation, or the computer program that produces numbers. My characterization comes only from talking to CBO staff.

Logical Pathways

This obscurity pervades government and its think-tank satellites. A report opines with great precision on the effects of policies. There is a model. But you can’t find what’s in the model or reproduce the numbers. Even where documentation exists, it’s buried. Most of all, the report never explains the logical pathways, the necessary but controversial “ifs” needed to arrive at the numbers.

Economic models aren’t engineering models. If you ask several aeronautical engineers to project how adding flaps affects an airplane’s takeoff speed, their models will be complex, but they will come up with about the same, and reliable, answers. You don’t need to know why.

But good economic models are quantitative parables, not authoritative black boxes. They only are trustworthy if they illustrate clearly understandable and explicitly stated pathways.

Numbers and models are important. The CBO needed to add up all the complex provisions of the law, and it is very good at doing this. If we retreat from numbers and models altogether, we cannot know, for example, that reversing the Bush-era income-tax cuts for “the rich” won’t make a dent in the deficit, let alone provide revenue for new programs.

But economic numbers cannot stand without the logic that produces them. Clarity and transparency are far more important to a good quantitative parable than the illusion of authoritative precision.

(John H. Cochrane, is a professor of finance at the University of Chicago Booth School of Business, an adjunct scholar of the Cato Institute and a senior fellow of the Hoover Institution. He blogs as the “Grumpy Economist.” The opinions expressed are his own.)

The future of central banks

A WSJ Op-Ed. Here is a pdf for non subscribers:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks' main task is to guide the economy by setting interest rates. Central banks' main tools used to be "open-market" operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These "nontraditional" interventions are not going away anytime soon.

Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative "stress tests" for them to pass, and haggle over thousands of pages of regulation. When we think of the Fed 10 years from now, on current trends, we're likely to think of it as financial czar first, with monetary policy the boring backwater.

A revealing example of where we are going emerged last spring, admirably documented on the Fed's website. Using its bank-regulation authority, the Fed declared that the banks that had robo-signed foreclosure documents were guilty of "unsafe and unsound processes and practices"—though robo-signing has nothing to do with the banks taking too much risk.

The Fed then commanded that the banks provide $25 billion in "mortgage relief," a simple transfer from bank shareholders to mortgage borrowers—though none of these borrowers was a victim of robo-signing.

The Fed even commanded that the banks give money to "nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development." Why? Many at the Fed see mortgage write-downs as an effective tool to stimulate the economy. The Fed simply used its regulatory power to help meet that policy goal.

Even if you think it's a good idea (I don't), a forced transfer from shareholders to borrowers in pursuit of economic policy is the province of the executive branch and Congress, subject to reproof from angry voters if it's a bad idea.

The Fed said candidly that it was acting "in conjunction" with the state attorneys general and the Justice Department. So much for an apolitical, independent Fed.

True, $25 billion is couch change in today's Washington. But you can see where we are going: Hey, nice bank you've got there. It would be a shame if the Consumer Financial Protection Bureau decided your credit cards were "abusive," or if tomorrow's "stress test" didn't look so good for you. You know, we've really hoped you would lend more to support construction in the depressed parts of your home state.

Conversely, when the time comes to raise interest rates, how can the Fed not consider that doing so will hurt the profits of the too-big-to-fail banks now under its protection?

This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system. Of course it will use its regulatory power to advance policy goals. Of course, propping up the financial system will affect monetary policy. If we don't like this sort of outcome, we have to break up the Fed into smaller agencies with narrowly defined mandates.

The European Central Bank's political power is, paradoxically, even greater. The ECB was set up to do less—price stability is its only mandate, and it is not a financial regulator. But the ECB holds the key to the euro-zone's central fiscal-policy question. It has bought the debts of Greece, Italy, Spain and Portugal, and it is lending hundreds of billions of euros to banks, which in turn buy more of those sovereign debts.

Eventually, the ECB will have to suck up this volcano of euros, by selling back the bonds it has accumulated. If it can't—if the bonds have defaulted, or if selling them will drive up interest rates more than the ECB wishes to accept—then the ECB will need massive funds from German taxpayers to prevent a large euro inflation. It might ask for a gift of German bonds it can sell, as "recapitalization," or it might ask for a bond swap of salable German bonds for unsalable southern bonds. Either way, German taxes end up soaking up excess euros.

Our views of central banks have changed every generation or so for centuries. The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s. It's happening again, and it would be better to think clearly about what we want central banks to do ahead of time.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

Myths and Facts About the Gold Standard

This is a July 28 2012  Wall Street Journal OpEd with a few of their cuts restored.

While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.

Let's start by clearing up some common misconceptions. Congressman Ron Paul's attraction to gold, and Federal Reserve Chairman Ben Bernanke's biggest criticism, is that a gold standard implies an end to monetary policy and the Federal Reserve. It does not.

Under a gold standard, the U.S. Treasury could exchange dollars for gold at a price of, say, $1,000 per ounce. In practice, that means banks would freely exchange their dollar accounts at the Fed for electronic claims to gold.

Nevertheless, the Fed could still buy government debt or other securities in exchange for newly created reserves, lend its reserves to banks, and set interest rates on its loans to banks. A gold standard would not stop the Fed from being the lender of last resort, bank regulator and financial crisis firehouse. For better or for worse.

This isn't theory. It's history. The Bank of England operated an active monetary policy under a gold standard for two and a half centuries. And the U.S. Federal Reserve was founded under the gold standard in 1914.

Moreover, the history of the gold standard is not just happy centuries of price-level stability. It is also a long history of crises, devaluations, suspensions of convertibility, and defaults on sovereign debt.

Debauching the currency—the great bugaboo of gold-standard champions—will always remain a temptation: If the government promises $1,000 per ounce and a recession comes along, it can say "we need to stimulate. Now it's $1,100 per ounce." In fact, such devaluation would be a much more effective way of deliberately causing inflation than today's zero interest rates, twists, and QEs. The left should be advocating a gold standard so they can devalue it! The success of a gold standard in achieving stable prices depends heavily on its rules and commitments against devaluation—rules honored in the past, until they weren't.

A gold standard also does not eliminate debt crises or debt-induced inflation. No monetary system can absolve a nation of its fiscal sins.

Imagine a government with $15 trillion of debt, $2 trillion of money outstanding, and $2 trillion of gold reserves. Then its debt comes due. If the government can't raise tax revenues, cut spending, or persuade investors to lend against credible future budget surpluses, it must print $15 trillion of cash not backed by gold, devalue the currency, or default on the debt. Worse, if people see that outcome looming, they will run to change their money for gold ahead of time, causing a crisis as the government's gold stocks run out.

A successful gold standard needs a clear way to deal with such crises. Here is one plan: Instead of printing unbacked cash, the government lowers the coupon payments on its bonds and notes—similar to the way corporations can cut dividend payments. Of course, this is effectively a gentle "default" in times of stress. But at least a fiscal impasse would not lead to a devaluation of the currency. Other plans are possible. Some clear expectations of how sovereign fiscal stress will be resolved is vital. Europe is now paying the price for its absence.

Yet if you don't expect magic, you are not disappointed by its absence. With these warnings, a modern version of the gold standard is attractive.

Why not the old version? Most of all because the value of gold is poorly linked to other prices in the economy, which is what we want to stabilize. Fixing the price of gold today would do little to control the general price level. There are two big reasons for the disconnection between gold and other prices.

First, in the past, inventory demand for gold coins linked the value of gold to other goods. If prices rose, people needed to hold more gold coins to make transactions. They would spend less on other goods and services, which brought prices down again. But that channel is absent in a modern economy. Since people could buy and transfer gold deposits with a click of a mouse, nobody would have to hold substantial inventories. And we are not going back to a 19th-century payments system based on lugging around gold coins.

Second, features that made gold such good money in the past—it is hard to produce and has few other uses—make its price especially badly connected to other prices. The relative price of gold has skyrocketed, yet few of us abandon our jobs to go mine gold, and few of us substitute buying gold to buy other things. These economic pressures to realign gold and other prices are nearly absent.

The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.

The Fed currently interprets "price stability" to mean 2% inflation forever. A CPI standard could enforce 2% inflation. But why not establish a price-level target instead? The CPI could be the same 30 years from now as it is today, and long-term contracts could carry no inflation risk. That is the real spirit of the Gold standard.

The Fed's main objection to a price-level target has been that 2% inflation gives it more stimulating power. With 2% inflation, setting a nominal interest rate of zero allows the Fed to achieve a negative 2% real interest rate, which may encourage people to borrow even more than at a zero real rate. Whether such interest-rate stimulation is needed, wise, successful on average, and worth its cost of perpetual inflation is the key question. I think not.

More deeply, the history of discretionary, shoot-from-the-hip monetary policy is one misstep after another, and of turbulence induced by guessing what the Fed will do. Since the demise of the gold standard, thoughtful economists have been searching for a replacement rule—Milton Friedman's money-growth rule, for example, John Taylor's interest-rate rule, and inflation or nominal GDP targets. Rules advocates understand that the economy works better overall with stable units, rather than the government manipulating units to trick us into buying more or less. A price-level standard is a firm rule.

In sum, a rule like the CPI standard could achieve the price-level stability that motivates the longing for a return to gold, avoiding the limitations of an actual gold standard in the modern financial system.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, an adjunct scholar at the Cato Institution, and a senior fellow at Stanford University's Hoover Institution.

Update: A few comments, such as John Tamny in Forbes interpreted

Nevertheless, the Fed could still buy government debt or other securities in exchange for newly created reserves, lend its reserves to banks, and set interest rates on its loans to banks. A gold standard would not stop the Fed from being the lender of last resort, bank regulator and financial crisis firehouse. For better or for worse.

to be a full-throated endorsement that we need a Fed to do all these things. Alas, the WSJ cut the "for better or for worse," which clarified that. But even without, I'm just saying gold won't stop the Fed, not that that the Fed must fulfill these functions. Actually, I'm quite a skeptic of the idea that the Fed must fulfill all these functions -- the first draft said "Gargantuan financial regulator" too, the Fed's main new function about which I'm really skeptical.  Words are at a premium in opeds, alas.

The big point here, though, is that the question of monetary standard is 99% distinct from these other activities of the Fed. Both are worth discussing. But they are separate issues.

Forget the mandate

(This is a Bloomberg "business class" oped, July 1. I got frustrated how the health care discussion has gotten stuck in a rut, "see, Obama's raising your taxes." "No, it's a penalty." Blah Blah.) 

On June 28, the Supreme Court upheld President Barack Obama’s health-care law. Opponents and supporters are still sparring over whether its mandate is a tax. It’s time to get over this debate. The mandate’s mild penalty was never this law’s central economic and policy flaw.

The distinctions among a mandate, a tax, a penalty, or a credit, and between federal and state powers, are important legally and constitutionally. But they are irrelevant in economic terms for this law.

To commentators who are apoplectic that the federal government is using taxes to nudge us to buy health insurance, I say this: Hello? The tax deduction for buying an electric car, or the mortgage-interest deduction for buying a house, is economically equivalent to a tax for not buying health insurance. Maybe all are bad, but did you really expect the Supreme Court to rule the mortgage-interest deduction unconstitutional in a case brought against the health-care law?

Let’s stop playing lawyer and get back to economics and policy. Opponents: Return to articulating the disastrous economic and health-care effects of this law. And articulate better ways to solve the mess. Supporters: Try to make this Rube Goldberg contraption work. Good luck.

On the July 1 “Meet the Press,” House Minority Leader Nancy Pelosi said: “If you are a person who has a child with diabetes, no longer will they be discriminated against because of a pre- existing condition. If you’re a woman, no longer will you have to pay more. No longer will being a woman be a pre-existing medical condition,” and “if you are senior, you pay less for your prescription drugs and nothing for a preventative check.”

She added: “And for everybody, no more lifetime limits on the coverage.” And young people will be covered by their parents’ policies.

A message to opponents: If all you (OK, we) can marshal in response is that you don’t like the legalities of a $1,000 penalty/tax for not buying insurance, we’re going to lose. And we should.

Let’s start with the obvious question: Who is going to pay for all this? Someone has to pay for every expanded benefit, whether through higher premiums, higher prices or higher taxes. And tapping “the rich,” reducing administrative costs or executive pay would just be a drop in the bucket. 

The more important fact is that the law won’t work.

Health care is a complex service, in which each person’s needs are blurry, and the line between “need” and “want” blurrier still. Imagine if the government decreed that law firms, car-repair shops, or home contractors had to charge everyone the same price, and couldn’t turn anyone away. “House fix,” for example, would be $1,000 per year, no matter how large the house or what shape it’s in. Why do we think this will work for medical services?

Health care will be rationed. Period. If we don’t ration by price, we will ration directly.

The Patient Protection and Affordable Care Act is a bureaucratic nightmare. About 2,700 pages of law, 13,000 pages of regulations and counting, 180 boards, commissions and bureaus, according to one media report.

It’s an invitation to crony capitalism. Thousands of companies have already asked for, and won, exemptions. They had better be in the good graces of the Department of Health and Human Services.

Enough. There are plenty of analyses of all the ways this law won’t work.

But one cannot complain without alternatives. “Repeal and replace?” OK, but with what? Pelosi’s promises address serious concerns. It isn’t enough to say “that costs too much,” or “it should be unconstitutional.”

Sensible alternatives exist. This need not be a choice between the Obamacare mess and the mess we had before.

Fix health care, not just health insurance. Where are the health-care equivalents of Southwest Airlines, Wal-Mart, and Apple -- innovating, dramatically lowering costs and bringing everyday low prices to health care? They have been kept out of the market by anti-competitive regulation. As one small example, in my state of Illinois, every new hospital, expansion of an existing facility or major equipment purchase must obtain a “certificate of need” from a state board. “Need” explicitly means that it doesn’t undermine incumbents’ profits.

Insurance should be insurance, reserved for unpredictable and catastrophic expenses. Car insurance doesn’t pay for oil changes, and you shouldn’t pay for checkups through health- insurance premiums. Such insurance would be a lot cheaper, and more people would buy it.

Insurance should be individual, portable from job to job and state to state, and guaranteed renewable for people who get sick. That neatly solves the pre-existing-condition nightmare. Insurance companies would be happy to sell such coverage. The government stands in the way, by subsidizing employer-based group plans at the expense of individual insurance. (My “Health status insurance” (see here and here)  proposal is one example among many that describe functional private health insurance.)

Cost control is achieved in only one way. Competition. Not price controls.

Innovation comes from competition, too, and from innovators’ ability to initially charge rich people more -- and their ability to pay it -- make great profits, and then commoditize. You cannot have innovation in a government cost- controlled system.

It takes courage these days to have any trust in markets, or for politicians to oppose handouts to voters. Without that courage, our health-care system, and our economy, will fall apart.

Money Market Runs

A good oped in Bloomberg's "Business Class" series tackles money market funds. (I signed it along with the rest of the Squam Lake group, but I can't take credit for much of the writing.)

There was a run in money market funds. We have to do something about this.


Money market funds are a bank. Their liabilities are fixed value, first-come first-serve, just like deposits. Their assets are longer term, and less liquid. This fact puts them at risk for a run. The essence of stopping future financial crises is stopping runs.

One way to stop a run is for the government guarantee all the liabilities. That stops the run, but gives horrible incentives to the fund managers, so now you need regulation.  This is what we did with banks and what the industry seems to want for money market funds. Watch for what you ask for, you just might get it.

The Squam Lake group, and others thinking about these issues, note two other eminently sensible possibilities.

First, money market funds can trade at net asset value, just like equity mutual funds or exchange traded funds. (The small difference between those doesn't matter here.) Now there is much less incentive to run. The situation that happened with the Reserve Fund in the financial crisis, that everyone sees net asset value less than a dollar per share and knows it's time to run, cannot happen.

This seems like the simplest fix. In the modern world, liquidity need not mean fixed value.

Alas, as the more knowledgeable Squam members informed me, this conceptually simple resolution to the problem causes accounting and tax problems. Money funds are used as money. If I have to pay you $1,000, it's easy to say "sell 1,000 shares and send the proceeds." It's much harder, technically, to say "sell $1,000 worth of shares and send the proceeds."

The tax issue is that if every transaction takes place at a different market value, then you have to track capital gains and losses on a huge number of transactions.

Say I, well, for a few hundred billion dollars we can surely fix these accounting and tax law problems (like get rid of capital gains tax!). Why accept that one bad regulation must beget another? But critics are right that this does spread the difficulty of making a change.

Second, money market funds can include capital just as banks do. If there is an equity tranche holding even a few percent of value, then money funds can promise $1 per share and always have net asset value above that. Banks have equity tranches. So can money funds. If we're going to maintain $1 per share, this seems like a no brainer, and basically what the Oped calls for.  The objections, like most objections to higher capital for banks,  basically don't understand the Modigliani Miller theorem.

That said, money market funds are a lot simpler than banks, and fixing the regulatory system is a bit less crucial in my view.

The chance of a systemic run is lower for money market funds. The danger in a systemic run is that bank A is found to be insolvent; people don't know what bank B's assets are, so they run just to be sure. That's not what happened at the Reserve Fund: People knew it held a lot of Lehman paper, and knew it was insolvent. People can see what assets the other money market funds had, and quickly verify if the did or did not hold Lehman paper.

The transparency of money market funds -- the fact that we know the net asset values  pretty well and the composition of assets -- makes the chances of a "multiple equilibrium" run or a "systemic" run a lot less than that of banks. 

Still, there is no reason to put up with runs at all, or to provide a blanket government guarantee, when fairly simple changes to the contracts can fix the problems.

Facilitating NAV trading or an equity buffer is important for another reason -- to expand money market funds and let them take on more risk.

The SEC has already started the "regulate" part of the traditional model by forcing money market funds to shorten the maturity of their assets. Great, but as forcing institutions to buy "AAA" debt subsidized the artificial creation of "AAA" assets, forcing funds to hold "short term" debt subsidizes creation of short-term liabilities. And short term debt anywhere is the poison in the well that causes crises. It encourages banks and other issuers to finance themselves with a lot of short-term debt, exactly the opposite of what we want.

You can move risk around, you can't eliminate it. Keeping the risk in the fairly transparent money market funds with a solid equity tranche rather than in the bowels of horribly complex too big to fail banks seems like a good idea.

Supreme court and health insurance part II

Yesterday's post morphed into a Wall Street Journal Op-Ed, reprinted below.

Why am I going on? I think too many people don't understand there is a coherent free-market, deregulated alternative. President Obama himself said today,

"I think the American people understand — and I think the justices should understand — that in the absence of an individual mandate, you cannot have a mechanism to ensure that people with pre-existing conditions get health care."   

This just isn't true. I don't blame Obama, but his health insurance advisers ought to know better. "Guaranteed Renewable," or "premium-increase insurance" is a possibility. It solves the genuine pre-existing conditions problem. It's been in the academic literature for almost 20 years (see e previous  Articles,  Opeds, Blog posts and citations in the Articles, especially to Mark Pauly's work and extensive coverage on Cato's health insurance and Universal Heath Care sites). A deregulated, competitive market can work. 

The WSJ Oped: 

Last week, the Supreme Court heard arguments on the constitutionality of the administration's health law, aka ObamaCare. Opponents are giddy with the possibility that the law might be struck down.

But what then? Millions of uninsured, both those who choose not to purchase coverage and those who can't due to pre-existing conditions, will still be with us. The rising costs and inefficient delivery of health care will still be with us.

The country can have a vibrant market for individual health insurance. Insurance proper is what pays for unplanned large expenses, not for regular, predictable expenses. Insurance policies should be "guaranteed renewable": The policy should include a right to purchase insurance in the future, no matter if you get sick. And insurance should follow you from job to job, and if you move across state lines.

Why don't we have such markets? Because the government has regulated them out of existence.

Most pathologies in the current system are creatures of previous laws and regulations. Solicitor General Donald Verrilli explained as much in his opening statement to the Supreme Court: "The individual market does not provide affordable health insurance," he noted, "because the multibillion dollar subsidies that are available" for the "employer market are not available in the individual market." Well, if the problem is subsidies, we know how to fix it!

Start with the tax exemption for employer contributions to group health-insurance policies—but if your employer contributes an individual, portable insurance policy, you pay taxes. This is why you have insurance only so long as you stay with one employer, why you face pre-existing conditions exclusions if you change jobs, and why individual lifetime insurance is unattractive to young healthy people who know they will be employed someday. 

Continue with the endless mandates (both state and federal) on insurance companies to provide all sorts of benefits people would otherwise not choose to buy. It sounds great to "make insurance companies pay" for acupuncture. But that raises the premiums, and then people choose not to buy the insurance. Instead of these mandates, at least allow people to buy insurance that only covers the big expenses.

What about Medicare and Medicaid? Two words: premium support. The underlying point of premium support is simple. If insurance costs $5,000 and the government gives an individual a $4,500 voucher, that individual will still feel the correct economic signal to shop for cost-efficient health insurance and health care.

The main argument for a mandate before the Supreme Court was that people of modest means can fail to buy insurance, and then rely on charity care in emergency rooms, shifting the cost to the rest of us. But the expenses of emergency room treatment for indigent uninsured people are not health-care's central cost problem. Costs are rising because people who do have insurance, and their doctors, overuse health services and don't shop on price, and because regulations have salted insurance with ever more coverage for them to overuse.

If we had a deregulated, competitive market in individual catastrophic insurance, that market would be so much cheaper than what's offered today that we would likely not even need the mandate.

Meanwhile, staggeringly inefficient markets for health care itself need a thorough, competition-focused deregulation. Americans will know there's a healthy market when hospitals post prices on their websites, and when new hospital and health-care businesses routinely enter to challenge the old ones. Here too regulations keep competition at bay.

The number of new doctors is still restricted, thanks to Congress and the American Medical Association. Congress caps the number of residencies, the AMA has fought the expansion of medical schools, state tests make it difficult for foreign doctors to work here, and on and on.

There are hundreds of government impediments to competition. New hospitals? In my home state of Illinois, every new hospital, expansion of an existing facility or major equipment purchase must obtain a "certificate of need" from the Illinois Health Facilities Planning Board. The board does a great job of insulating existing hospitals from competition if they are well connected politically. Imagine the joy United Airlines would feel if Southwest had to get a "certificate of need" before moving in to a new city—or the pleasure Sears would have if Wal-Mart had to do so—and all it took was a small contribution to a well-connected official.

The result is a monstrous system in which insurance patients are gouged to subsidize Medicare, and cash patients are gouged most of all. Here's Mr. Verrilli again: "Insurance has become the predominant means of paying for health care in this country." Yes, the cash market has been badly damaged. Whose fault is that? Shouldn't we bring it back?

Group health plans in today's system may appear reasonable enough—they seem to resemble "buyers' clubs," where people pool together to get good deals from providers. But in a real buyer's club, each buyer still pays his own bill—you don't go into a Sam's Club and haul off whatever you can with only a fixed $20 copayment. And real buyer's clubs don't depend on where you work. Real buyers' clubs for health services could be a useful way to get competition going and revive the cash-and-carry market for individuals.

A deregulated health-care and health-insurance market can work. We can at least start by removing the obvious elephants in the room: all the legislation, regulation and interventions that needlessly keep prices up, keep competition and innovation out, shelter people from the economic consequences of their decisions, and prevent the emergence of real insurance that follows you from job to job and from health to illness and back.

Austerity, Stimulus, or Growth Now?

(This is also a Bloomberg "Business class" column, with minor improvements.)

Austerity isn't working in Europe. Greece is collapsing, Italy and Spain’s output is declining, and even Germany and the U.K. are slowing down. In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms.

These events have important lessons for the U.S. Our government cannot forever borrow and spend 10 percent of gross domestic product each year, with an impending entitlements fiasco to boot. Sooner or later, we will have to fix our finances, too.  Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path.

Why is austerity causing such economic difficulty? What else should we do?


Lack of “stimulus” is the problem, say the Keynesians, epitomized by the New York Times and its columnist Paul Krugman, who has been crusading on this point. They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They -- and we -- just need to spend more. A lot more.

Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates, they point out. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?

The traditional Keynesian answer was: move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves. In a March 17 column, Krugman wrote: “there’s a plausible case that spending more now actually improves the long-run fiscal picture.”

U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't.

Is there another explanation, and a more plausible way forward?

The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?

Does it not matter that Greece has a high combination of individual, corporate, wealth and social taxes, higher still under "austerity?" True, Greeks famously don’t pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation (the IMF predicts 35 percent in Greece, should it leave), and capital controls, have nothing to do with lack of investment?

Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines. Yet investment and production aren’t turning around. Greek “demand” needn’t matter -- the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the Eurozone. But it isn't happening. Is that a mystery? Would lower wages compel you to invest money in Greece, surmount a thicket of regulation, expose yourself to the threats of wealth, property and business taxation, currency expropriation and capital controls, or even nationalization?

In sum, isn't it plausible that a good part of Europe’s austerity doldrums are linked to “supply,” not “demand,” “microeconomics” not “macroeconomics,” weeds in the economic garden, not a want of fertilizer? Isn't it plausible that factors beyond simple declines in government spending matter in the economy’s response to a debt crisis?

That insight suggests a different strategy: Let’s call it “Growth Now.” Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very stimulative, not the mythical (and curiously carbon-intensive)  roads and bridges, and most of that goes to people who are relatively well off

Rather than raise tax rates further on “wealth” and the “rich,” driving them underground, abroad, or away from business formation, fix the tax code, as every commission has recommended. Lower marginal rates but eliminate the maze of deductions. In Europe, eliminate the fears of wealth confiscation, euro breakup and currency devaluation that are driving saving and investment out of the south.

Most of all, remove the profusion of regulation and (increasingly) direct government management of the economy.

Growth is the key to paying off debts. The only way to escape large debt/GDP ratios is to embark on a decade or more of solid  growth. Growth like this comes from long-run productivity, not short-run stimulus. 

Europe is beginning to figure this out. Italy’s prime minister, Mario Monti, is addressing his country’s debt crisis by proposing far-reaching deregulation, now. While his proposals aren't complete or close to radical enough, and they are combined with some unfortunate business-stifling tax increases, it’s remarkable that anyone in Europe is beginning to talk about this approach.

“Structural reform” is vital to restore growth now, not a vague idea for many years in the future when the stimulus has worked its magic. Europe learned that it’s also a lot harder politically than the breezy language suggests. “Reform” isn’t just “policy” handed down by technocrats like rules on the provenance of prosciutto; it involves taking away subsidies and interventions that entrenched interests have grown to love, and support politicians to protect. They will fight it tooth and nail.

That is even more reason to address growth now, while there is a crisis. The will to do so will evaporate if better times return, and the ability to do so will disappear if the economies plunge.

The Real Trouble With the Birth-Control Mandate

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

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

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

I put "insurance" in quotes for a reason. Insurance is supposed to mean a contract, by which a company pays for large, unanticipated expenses in return for a premium: expenses like your house burning down, your car getting stolen or a big medical bill.

Insurance is a bad idea for small, regular and predictable expenses. There are good reasons that your car insurance company doesn't add $100 per year to your premium and then cover oil changes, and that your health insurance doesn't charge $50 more per year and cover toothpaste. You'd have to fill out mountains of paperwork, the oil-change and toothpaste markets would become much less competitive, and you'd end up spending more.

How did we get to this point? It all leads back to the elephant in the room: the tax deductibility of employer-provided group insurance. 

If your employer pays you $100 less in salary and buys $100 of group insurance for you, you don't pay taxes on that amount. Hence, the more insurance costs and covers, the less in taxes you seem to pay. (Even that savings is an illusion: The government still needs money and raises overall tax rates to make up the difference.)

To add insult to injury, this tax deduction does not apply to portable, guaranteed-renewable individual insurance. You don't get the tax break if your employer gives you the $100 and you buy a policy—a policy that will stay with you if you get sick, leave employment or get divorced. The pre-existing conditions crisis is largely a creature of tax law. You don't lose your car insurance when you change jobs.

Why did HHS add this birth-control insurance mandate—along with "well-woman visits, breast-feeding support and domestic-violence screening," and "all without charging a co-payment, co-insurance or a deductible"—to its implementation of a provision of the new health-care reform law? "Because it promotes maternal and child health by allowing women to space their pregnancies," says the HHS advisory panel. Because these "historic new guidelines" will make sure "women have access to a full range of recommended preventive services," says the original HHS announcement. To "increase access to important preventive services," echoes White House Press Secretary Jay Carney.

Notice the doublespeak confusion of "access" and "cost." I have "access" to toothpaste because I have two bucks in my pocket and a competitive supplier. Anyone who can afford a cell phone can afford pills or condoms.

Poor women who can't afford birth control are a red herring in this debate. HHS isn't limiting this mandate to the poor. We all have to pay. The very poor typically don't have employer-provided health insurance in the first place.

"Allowing women to space their pregnancies"? Was there some sort of federal ban on birth control before this?

It's not about "access" and it's not about "insurance." It's because Americans, when paying even modest co-payments, choose to spend their money on other things. They prefer a new iPod to a "wellness visit" to the doctor. As the HHS unwittingly admits: "Often because of cost, Americans used preventive services at about half the recommended rate."

Remember, we're supposed to be worrying about skyrocketing health-care expenses. Doubling the number of wellness visits and free pills sounds great, but who's going to pay for it? There is a liberal dream that by mandating coverage the government can make something free.

Sorry. Every increase in coverage means an increase in premiums. If your employer is paying for your health insurance, he could be paying you more in salary instead. Or, he could be lowering prices and selling his product to you and all consumers more cheaply. Someone is paying. Not even HHS tries to claim that these "recommended preventive services" will lower overall costs.

Here's a good mandate: Let's mandate that every time a government official says that the government is going to "help" some category of voter, he or she has to say who they are going to hurt in the same sentence. Because it has to be someone.

But what about the fact, you may ask, that unwanted children are a burden on society as well as to their mothers? Perhaps there is a social interest in subsidizing birth control? Perhaps there is—but if so, this is an awful way to do it.

If pills are "free," under insurance, the incentive for drug companies to come up with cheaper versions vanishes. So does their incentive to develop safer, more convenient, male-centered or nonprescription birth control. And by making pills free but not condoms, the government may inadvertently be contributing to an increase in sexually transmitted diseases.

The taxes and spending we argue about are the tip of the iceberg. Salting mandated health insurance with birth control is exactly the same as a tax—on employers, on Catholics, on gay men and women, on couples trying to have children and on the elderly—to subsidize one form of birth control.

If the government wants to subsidize birth control, OK, pass an explicit tax, and sensibly subsidize all birth control. And face the voters on it. The tax rate and spending debates that occupy the media are a small part of the effective taxes and spending that the government achieves by these regulatory mandates.

There is also the issue of religious freedom. Our nation is divided on social issues. The natural compromise is simple: Birth control, abortion and other contentious practices are permitted. But those who object don't have to pay for them. The federal takeover of medicine prevents us from reaching these natural compromises and needlessly divides our society.

The critics fell for a trap. By focusing on an exemption for church-related institutions, critics effectively admit that it is right for the rest of us to be subjected to this sort of mandate. They accept the horribly misnamed Patient Protection and Affordable Care Act, and they resign themselves to chipping away at its edges. No, we should throw it out, and fix the terrible distortions in the health-insurance and health-care markets.

Sure, churches should be exempt. We should all be exempt.

(All health-insurance artilcles and opeds)

The Fed's Mission Impossible

A Wall Street Journal Op-Ed  reviewing the latest  Fed's proposal (press release) to regulate big banks -- and, soon, everyone else. Here's the much more fun introduction, which we had to cut for space,

Imagine that your brother-in-law and his 5 buddies are heading for Las Vegas. Again. You already cosigned the refi on his house, and it was only a last-minute wire to the bail bondsman that got him out of the slammer last time.

So, you’re going to have another little kitchen-table talk about “the rules.” This time, no lending to your buddies (“limits on credit exposure”). No buying rounds of drinks (“limit dividend payouts and bonuses”). And for God’s sake, don’t lose it all on one silly bet (“stress test”). Keep some cash for the flight home (“liquidity provisions.”) No pawning the wife’s engagement ring for one last double-or-nothing (“leverage limits”). And if I hear there’s trouble, I’m going to come out myself and make sure you don’t overdo it. (“Early remediation”)

Sure, he says, with a twinkle in his eye. Because you both know he’s got your credit card, and you’re not going to let your sister live in poverty (“systemically important”). And you can’t talk about her dumping this lug (“breaking up the big banks”), or at least stopping these Vegas trips (“Volker Rule”), not unless you want to sleep on the couch for a month (“Dodd Frank”).

On to the real oped:

The Fed's Mission Impossible

The Federal Reserve last week announced its new "Enhanced Prudential Standards and Early Remediation Requirements" for big banks, as required by the Dodd-Frank law. You have to pity the poor Fed because it faces an impossible task.

The Fed's proposal opens with an eloquent ode to the evils of too-big-to-fail and moral hazard. And then it spends 168 pages describing exactly how it's going to stop any large financial institution from ever failing again.



More capital is at least a step in the right direction. But the Fed's capital proposals don't go nearly far enough. Putting less than one investor dollar at risk for every 10 borrowed dollars seems laughably low when we're guaranteeing the debts. With a 50-50 chance of a banking tsunami coming across the Atlantic from Europe, you wonder why the Fed is allowing any dividends at all.

But there's nothing here to solve the deeper problems. The last generation of smart MBAs got around capital requirements by pooling risky assets into "AAA" securities that had lower risk weights, and then putting those securities in special-purpose vehicles with off-balance-sheet credit guarantees. Voilà! Same risk, no capital. I can't wait to see what they come up with this time. Diligently following risk weights, European banks built capital ratios by selling good loans and keeping "risk-free" sovereign debt.

The Fed's proposed "credit limits" are a revealing mess. They seem simple and obvious—big banks can't bet more than 10% of their equity on a single counterparty.

But on second thought, it's not so obvious. This wasn't the problem we had in 2008. Banks didn't fail because they lent to other banks. We had a classic run: Investors pulled money from banks that lost a lot on mortgage-backed securities. Yes, banks take too much risk. But they have no incentive to take stupid undiversified counterparty risk.

Credit limits are not so simple either. Suppose you buy a $100 Bank of America bond. OK, you have $100 at risk, though usually there is some recovery in default. But what if they give you $102 of collateral, yet that collateral might be hard to sell or stuck in court for a while? How does a regulator measure that risk? Or what if loans from A to B are funneled through shell company C using derivatives? Ten percent of equity is less than 1% of assets, and a tiny fraction of gross exposures, so measuring it right will matter a lot.
How does the Fed address these problems? Read the 22 pages of overview with 39 separate explicit questions. Translation: Help! We have no idea how to measure and regulate "credit exposure" for modern banks.

The Fed's proposed "triggers" for "early remediation" are interesting attempts to regulate the Fed, not the banks. The Fed recognizes that last time "while supervisors had the discretion to act more quickly, they did not consistently do so." Triggers will force the machinery to action.

Or will they? You're a regulator facing a bank in trouble. If you label it in trouble, you will start a panic in markets. This is the inherent contradiction—your job is to prop up banks, not cause runs. We'll see.
The Fed goes on to a chilling list of "corporate governance" rules, gems such as: "The covered company's board of directors (or the risk committee) must oversee the covered company's liquidity risk management processes . . . [and] determine whether each line or product has created any unanticipated liquidity risk." Well, duh, isn't that what boards do? Why must this be written into federal regulations, with force and penalty of law?

The Fed's proposal exemplifies what a recent editorial in these pages described as Washington's "badly written bad rules." Everything under the sun gets regulated, with no attempt to measure benefits or costs. Sure, as the Fed make clear, Dodd-Frank is to blame, but it could fight back just a bit.

Big picture time. Is any of this going to work?

For 70 years, our government has sought to stop crises by guaranteeing more and more debts, explicitly with deposit insurance, or informally with predictable too-big-to-fail bailouts. Guaranteeing debts gives obvious incentives to gamble at taxpayer expense, so we try to limit risks with regulation. But big banks still have every incentive to avoid, evade and financial-engineer their way around the rules, and they have lots of lawyers, lobbyists and ex-politicians to pressure regulators to use their wide discretion. The government has lost this arms race time and time again. Will this new round of rules, and greater discretionary supervision, finally stop too big to fail?

The depressing scenario is that the six big banks will use this massive regulation as an anticompetitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with continuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965.

The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year's Dodd-Frank financial legislation and the Fed's rules, which allow the government to step in whenever they decide that a financial risk is "systemically important."

What is not "systemically important?" How I can I build a new financial company that demonstrably causes no "systemic" danger—and is therefore not subject to the Fed's onslaught of regulation, discretionary supervision and "remediation"? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized "resolution"?

The Dodd-Frank legislation never defines "systemic" or, more importantly, its absence. Under the law, the Financial Stability Council can just "determine" that any company might have "serious adverse effects on financial stability." They can consider any "factors that the Council deems appropriate." The Fed proposes to subject any company to "other requirements or restrictions" if it thinks existing rules do not "sufficiently mitigate risks to U.S. financial stability."

There is nothing to say that a risk to "financial stability" can't be, for example, taking profits away from the big six, or a failure that takes money away from an influential voting bloc. Don't laugh: Life insurance companies were bailed out in 2009 at least in part so they could keep up payments on guaranteed-return retirement products.

The Fed does not propose any such limit to its powers or describe how it will encourage a financial system free of too-big-to-fail firms. The Fed's report has instead a searching inquiry on how it can expand its powers, and how it can begin "designating" and regulating companies beyond the big banks.

If we are going to get out of the guarantee-regulate-bailout trap, we must legally define what is not too big, and what can, will and must—by absence of legal authority—fail. If the government won't break up too-big-to-fail banks, we must at least allow competition to do it.