Cowen on Finance and Inequality

In his American Interest essay, "The Inequality That Matters," Tyler Cowen offers a number of reasons not to be too troubled by the general rise in income inequality over the last 30 years (not surprising given his generally libertarian-ish outlook).  As he notes, much of the increase in inequality is really occuring within the top 1% of incomes, and much of that is driven by the financial sector.  That, according to Cowen, is where the real problem lies. Along the way he also offers one of the best nutshell explanations for why financial sector incomes exploded to such monsterous proportions:

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed. 

Furthermore,

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks. 

Like Keynes said:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

Back to Cowen:

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.

Run-RMB

Taiwan's next media animation illustrates Sino-American tensions over currency policy with a rap video:

The Failure of Say's Law

as illustrated by the Washington Post's Tom Toles:

A Semi-Defense of the Textbook Money Multiplier

John Taylor approvingly cites a JPMorgan note criticizing economics textbooks' treatment of the money multiplier.  The money multiplier relates the monetary base, which is directly manipulated by the Fed's open market operations, to the money supply, which is what actually affects the economy in most economic models.  The very simple version of the calculation is that the money multiplier is 1/rr where rr is the "reserve ratio" of bank reserves to deposits.

If one assumes a constant money multiplier, then the dramatic increase in the monetary base since mid-2008 implies a huge (and frighteningly inflationary) increase in the money supply.

According to JP Morgan:

The growth of the Fed’s balance sheet, which has been funded by an increase in commercial banks’ reserve balances at the Fed, has sparked fears that the “money multiplier” mechanism would translate those reserves into an explosion in bank lending, bank deposits, and inflation. None of these things has happened, because the money multiplier no longer makes sense given the institutional framework of the contemporary banking system. In spite of being almost totally divorced from reality, the money multiplier is still taught in undergraduate economics textbooks, with much resulting confusion.

While there have been quite a number of changes in the "institutional framework," which textbooks (and professors) may not want to treat in detail, the most basic flaw in the analysis which is being attributed to "undergraduate economics textbooks" is naively assuming a constant money multiplier.

I don't think that is a fair accusation.  Indeed, the only reason why money multipliers are interesting to talk about in class is that they can change.  In normal times, it makes sense for banks to hold as few reserves as they can get away with (they can lend excess reserves on the "interbank" loan market, and if they're short, they can borrow them, too).  But in unusual times, the calculation changes and banks respond to a riskier environment by holding more reserves, which reduces the money multiplier.

This issue normally enters an undergraduate economics course in a discussion of the Great Depression.  Milton Friedman and Anna Schwartz showed that the money multiplier fell during the banking panics of the early 1930's.  Because of the fall in the money multiplier, the money supply actually was decreasing even as the Fed increased the monetary base. This example has become part of the case the Fed bungled the depression. Both the Mankiw and Abel and Bernanke intermediate macroeconomics textbooks discuss this case immediately after algebraically deriving the money multiplier.

The sudden increase in the monetary base (blue line) occurred in late 2008.  In the same period, deposits (red) also rose, but much less dramatically, which means there was a large increase in the reserve ratio.

The Fed announced on October 6, 2008 that it would begin paying interest on reserves.  This is is the dominant factor in the increase in both the quantity of reserves and the reserve ratio.  Interest on reserves does indeed represent a significant change in the institutional framework which isn't included in traditional textbook treatments.

However, looking a little more closely at the graph one can see that reserves began to increase in September.  Reserves rose from $9bn on Sept. 10, to $47bn on Sept. 17 and $104bn on Sept. 24 - a more than tenfold increase over two weeks.  Those two weeks, of course, were the absolute worst days of the financial panic of 2008 (Lehman declared bankruptcy on Sept. 15).  At a time when the interbank lending market suddenly appeared risky, it is not surprising that banks would exercise more caution and increase reserves, thereby reducing the money multiplier.  And that is likely quite consistent with what students read in their undergraduate economics textbooks.

Stimulus III: Return of the EGTRRA

Not surprisingly, our political discourse has a hard time wrapping its head around the fiscal policy conundrum that we currently face, which is that we need more stimulus (bigger deficits) now, but long-run budget projections imply that we need to make future deficits smaller, because we are likely to still have a deficit when the economy returns to full employment and it may balloon further in the future mainly because of rising healthcare costs.

There is a valid concern that, when the economy recovers, the federal government's large borrowing needs could "crowd out" investment.  While there is absolutely no evidence that this is a problem now or in the immediate future (as evidenced by continued low Treasury yields), the scheduled reversion of the tax code to the status quo ante-Bushum does create a unique opportunity to deal with the long run problem.

As it happens, the projected level of revenue if the tax cuts expire looks close to about right in the long run (see the "extended baseline" in the CBO's long-run outlook).  While the Clinton-era tax code isn't ideal in terms of equity or efficiency, clearly we didn't do too badly when it was in effect.  The beauty of "current law" is that it makes Washington's natural tendency towards gridlock work for, rather than against, a solution.  All we need is for any of (i) congress to not agree, (ii) a Senate filibuster not to be overcome, or (iii) the president not to sign, and our deficit problem is largely solved.

If unemployment wasn't 9.8%, I might therefore be in the "let them expire" camp (even the "middle class" parts), but, as things stand, the economy urgently needs more fiscal policy support now.  A tax increase is the exact opposite of what we need in the short run.

Before this week's deal between the administration and Republican leadership, my preferred outcomes, in order of preference, would have been:

1. The expiration of the tax cuts is used to force a tax reform that simplifies the tax code and eliminates tax expenditures (i.e., closes loopholes).  This broadening of the tax base could raise revenue, and maintain progressivity (since it is high incomes that benefit most from loopholes), while keeping marginal rates low.  The Bowles-Simpson proposal did move in this direction - on progressivity, it landed between the Clinton and Bush tax codes (according to the TPC) - but it had an arbitrary cap on revenue at a too-low level.  At full employment, the ideal reform would be revenue neutral compared to a "current law" baseline (i.e., it would bring in the same revenues as the Clinton tax code over the long-run).  The short-run negative effect of the resulting tax increase would be offset (and thensome) with explicitly temporary fiscal stimulus, perhaps with a built-in trigger mechanism to unwind it automatically as the economy recovers, which would serve to minimize the inevitable push for extensions.
2. The tax cuts are allowed to expire, reverting to the Clinton-era tax code, but accompanied by the same type of stimulus described above.
3. The original Obama-Democratic policy of making the "middle class" tax cuts permanent while reinstating the Clinton-era rates for income above $250K.  Raising taxes on the rich is anti-stimulative, but not very (the multiplier is low), so the long-run deficit reducing benefit outweighs the short-term cyclical cost.
4. The whole thing expires (which may still happen - its not clear the deal will get through Congress), which solves our long run problem, but leaves us hoping even more fervently that Fed gets enough traction to keep the recovery going, even as the tax increase makes the headwinds stronger.
5. The preferred Republican policy of making all the tax cuts permanent, which has the virtue of not making things worse in the short run, but will eventually lead us back to the low-investment economy of the late 1980's and have us talking about cutting social security and medicare.

I'd put this week's deal somewhere between #2 and #3, and given that #3, 4 and 5 seemed to be what was realistically on the table, I can't be too disappointed (even if I sympathize with the widespread concern that President Obama's poker skills seem to have mysteriously diminished).  One concern is that extending the Bush tax cuts entrenches them further and increases the risk that they become one of those features like the alternative minimum tax "patch" that we expect to be perenially "fixed." But the two-year extension does leave open the possibility of something like #1 or #2 happening in 2012, and at least we haven't decisively dug the long-term hole deeper as #5 (and, to be honest, #3) would.  We have also averted the short-run damage that would result from #4 (and to a much lesser extent, #3).  Not only have we avoided that anti-stimulus, but the deal includes other demand-enhancing provisions, like the one-year payroll tax cut (which replaces the expiring "making work pay" credit from the 2009 stimulus bill, but is bigger, though less progressive).

David Leonhardt calls it a "second stimulus" (third, if you count the spring 2008 tax rebate).  The Center for American Progress applied existing multiplier estimates to the deal's provisions to estimate that it would increase employment by about 2.2 million (relative to unemployment of 15 million). Macroeconomic Advisors estimates a GDP growth bump of 0.5-0.75 percentage points.  (Both of these come to my attention via the invaluable Ezra Klein).

Of course, it would be better still if the unemployment insurance extension was for two years (even if the recovery gathers steam, there will still be many people unemployed in 2012), and included something for the "'99ers" who have hit the 99-week limit on benefits (recall that the recession began at the end of 2007).  They also should have raised the debt ceiling, so it doesn't become the next "hostage".  One might hope the outrage of Congressional Democrats gives them some leverage to make improvements (indeed, if the Democrats were an organized political party, I might think there was a clever "good cop, bad cop" routine being employed here).

Note: the title of the post refers to the official name of the 2001 tax cut, the Economic Growth and Tax Relief Reconciliation Act.

Barack Obama's Time Consistency Problem?

When I explain the time-consistency problem to my students, I begin by asking them what the stated position of the government is about negotiating with hostage takers.  They know, of course, that the official line is that the government will not negotiate.

The reason why governments always say they will not negotiate with hostage takers is that, if they won't negotiate, there is no incentive to take them in the first place.  But, once hostages have been taken, the government has a strong incentive to negotiate because they don't want to be responsible for the hostages getting killed.  And the problem is that the would-be hostage takers understand this, and therefore do not believe the government will follow its announced policy of not negotiating.

That example may not work next semester, if my future students saw President Obama's press conference:

I’ve said before that I felt that the middle-class tax cuts were being held hostage to the high-end tax cuts.  I think it’s tempting not to negotiate with hostage-takers, unless the hostage gets harmed.  Then people will question the wisdom of that strategy.  In this case, the hostage was the American people and I was not willing to see them get harmed.  

One of the implications of the time consistency problem is that a better outcome would be achieved if the government didn't have discretion to negotiate with the hostage takers.  In the real world, no perfect "commitment technology" exists so, in practice, we think about "credibility".  That is, how can the government behave so that the prospective hostage takers believe the authorities really mean it when they say they won't negotiate?

So, the question is: did President Obama diminish his credibility, thereby increasing the likelihood of future political "hostage" situations, or did he just say what everyone already knows?  And was the Republican threat credible to kill the hostages let the tax code revert to its 2000 levels if the tax cut extension for incomes over $250,000 wasn't included?  (John Boehner's slip in September notwithstanding).

For background on time consistency and more examples, see Greg Mankiw, this speech by Charles Plosser, and the Nobel Prize information about Kydland and Prescott. 

Bernanke on 60 Minutes

Euro Trouble

Another sign the euro is in trouble: this week's Economist has an article on how a member country might leave the currency union.  It concludes:

The cost of breaking up the single currency would be enormous. In the ensuing chaos and recrimination, the survival of the EU and its single market would be in jeopardy. But by believing that a break-up cannot happen, the euro zone’s authorities will always tend to stop short of the radical measures needed to hold the project together. Given the likely and devastating chaos, it would be a mistake for a country to choose to leave. But mistakes occur in times of stress. That is why some are beginning to contemplate the unthinkable.

Germany may be the country that walks - the Guardian reports:

At the Brussels dinner on 28 October attended by 27 EU heads of government or state, the presidents of the European commission and council, and the head of the European Central Bank, witnesses said Papandreou accused Merkel of tabling proposals that were "undemocratic".

"If this is the sort of club the euro is becoming, perhaps Germany should leave," Merkel replied, according to non-German government figures at the dinner. It was the first time in the 10 months since the euro was plunged into a fight for its survival that Germany, the EU's economic powerhouse and the lynchpin of the euro's viability, had suggested that quitting the currency is an option, however unlikely.

Much of the difficulty in Europe stems from German attitudes on monetary policy (though their deeply ingrained aversion to inflation is understandable) and their influence on the ECB.  Ryan Avent put it well last week:

A demonstration of commitment to Europe requires a little bit from everyone, and what it requires from the ECB is that it act like the European Central Bank, rather than just a Bundesbank that gets to impose unreasonably hard money on everyone in the single currency. Mr Trichet, who has had to earn his post by acting as German as a Frenchman can possibly be expected to act, seems to be realising that that's not actually what's required of the ECB.

The recent "bailout" of Ireland does not impress Barry Eichengreen:

The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.

According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.

This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

Even measures like this, which fall far short of what would be necessary to end the crisis, are tough to get the Germans to sign off on.  Though its not surprising that loans to Greece and Ireland are bad politics in Germany, it needs to be remembered that the problems of some of the peripheral countries are due, in part, to the fact that ECB policy, which placed more weight on Germany (because its bigger) was too loose for them. This helped create the bubbles that have now burst.  Moreover, much of the debt involved is owed to German (and other European) financial institutions, so this is really a "bailout" of Germany's banks.

Europe faces both sovereign debt and monetary policy problems.  Some of the countries have too much debt, and a restructuring is probably in order.  But if they're going to avoid that - and they seem determined to (though don't they always?) - a more expansionary monetary policy would help them grow (and inflate) their way out of trouble.  Without more inflation, the peripheral countries really need not just loans, but fiscal transfers from those that are in better shape (i.e., some kind of fiscal union is needed - on this, see Gavyn Davies).

Neither way out seems palatable to Germany.  The Economist's article argued that the disruption of leaving the euro would be considerably lower for Germany than for the peripheral countries, since the likely appreciation of the Mark would ease some of the tangles associated with re-denominating debt.  Perhaps the rest of the eurozone should consider taking Chancellor Merkel up on her offer...

Now, That's an Economic Message

When I read the "Economic View" column in today's NY Times:

Uncertainty is likely holding back the recovery. But its sources are far more fundamental than the tax and environmental issues that typically top the list of complaints. And the solution is certainly not for the government to do less. Rather, it needs to do much more...

Wall Street analysts often cite possible government regulations on the environment as another source of damaging uncertainty. But as with the deficit, inaction could be far more damaging than action. Climate change and dependence on foreign oil are problems that won’t go away on their own. Tabling plans to deal with them doesn’t make it easier for companies to plan and invest; it makes it harder.

Until businesses and communities know the costs and incentives for developing renewable energy, nuclear power and natural gas — and whether we will address climate change through prices or direct regulation — it will be very hard to invest in new power sources and related industrial technologies.

The deepest and most destructive uncertainty we face centers on the overall health of the economy and its prospects for growth. Unlike other postwar recessions that were caused by tight monetary policy and high interest rates, the recent downturn resulted from the bursting of a housing bubble and a financial crisis. Because we are in largely uncharted territory, figuring out how and when the economy will recover is much harder than usual...

How do we resolve uncertainty about future growth? The Federal Reserve, Congress and the president need to reaffirm that they will do whatever it takes to restore the economy to full health. They could take a lesson from President Franklin D. Roosevelt, who declared in his 1933 inaugural address that he would treat the task of putting people back to work “as we would treat the emergency of a war.” 

I think: now that is exactly the kind of message we need to hear from the White House.  And then I see that the column was written by Christina Romer, who was, until very recently, chair of the Council of Economic Advisors....

What We Believe and the Tools We Use

At Worthwhile Canadian Initiative, Nick Rowe writes:

What we research, and what we believe, aren't necessarily the same thing. What gets published in the journals is a survey of what we are currently researching. It isn't an accurate survey of what we currently believe. The whole point of a journal is not to publish what everybody already believes. The journals are a map of where we are currently exploring for gold. They are not a map of existing gold deposits. They are not a map of where we think gold might be found in places we can't currently explore.

To which I might add, economic models can be thought of as tools.  Using a particular tool (model) to do a job (normal science) shouldn't be taken to imply a belief that the model is the right one for all economic phenomena.  In many cases, its much easier to make progress (and get papers accepted) if one uses existing tools.  For instance, I've used a real business cycle model in my own research - it turned out to be an effective device to implement an idea I had about real exchange rate volatility.  But it does not mean that I believe that real business cycle theory is a correct explanation of economic fluctuations.

Its Hard to Hold a Candle

in the cold November rain....

The BLS November employment report is a bummer, especially in the wake of mostly improving economic reports (e.g., consumer confidence, unemployment insurance claims, regional manufacturing surveys, etc).

According to the BLS, employment increased by a mere 39,000 and the unemployment rate rose from 9.6 to 9.8%.

The rise in the unemployment rate was not, alas, due to people re-entering the labor force - the participation rate was unchanged at a (depressed) 64.5%.  According to the household survey, 173,000 fewer people were employed in November (recall that the headline employment number comes from the separate survey of businesses, while the unemployment rate is calculated using the household survey).

If the other, positive, economic reports are ultimately reflected in strong fourth quarter GDP, the employment numbers would be an indication of rising productivity (for the third quarter, the BLS reported 2.3% labor productivity growth).

Out of the 15.1 million unemployed (!!!!), 6.3 million have been unemployed for more than 27 weeks.  There was a good article yesterday in the Times on how long-term employment can have persistent effects, as people who have been unemployed for a long time become less employable (a form of what is sometimes called "hysteresis" in the economics literature).

Hopefully the report will concentrate some minds in Washington (but don't hold your breath).  It should strengthen the President's attempt to salvage an extension of unemployment benefits from the negotiations with the Republicans on extending the Bush tax cuts.

November is one of the months when the seasonal adjustment makes things look worse - on an unadjusted basis, the unemployment rate was 9.3% (up from 9% in October), and payroll employment increased by 217,000.

For more on the employment report, see Calculated Risk, David Leonhardt, Free Exchange, and Real Time Economics' roundup.

Update: Mark Thoma is critical of the White House response.  Floyd Norris has a reason to hope for an upward revision.