Monthly Archives: June 2014

Re-telling the AIG story

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Hester Peirce writes,

AIG’s securities lending program is just as critical to the story of its downfall. Through the securities lending program, AIG and its life insurance subsidiaries had massive exposure to residential mortgage-backed securities. At the height of the 2008 crisis, the program experienced a run, and AIG could not meet the massive repayment demands. The losses in the securities lending program were severe enough to imperil a number of AIG’s regulated life insurance subsidiaries. Before the bailout, AIG itself may have been insolvent.

The standard story is that all of the problems at AIG were caused by its credit default swaps. As those out-of-the-money options came closer to being in the money, their counterparties exercised rights to collateral calls, creating a liquidity crisis for AIG.

I have always accepted the standard story, and my view is that the way to handle it would have been to block the collateral calls. Make Goldman Sachs and DeutscheBank and everyone else wait to see how things play out.

Peirce says that in addition to the collateral calls on credit default swaps, AIG had exposure to mortgage securities through its regular insurance subsidiaries’ portfolios. Those securities lost market value during the crisis. For AIG, the problem became acute because of its securities-lending business. I don’t think I understand completely how this securities lending worked, but I think that the effect was to create a very significant maturity mismatch for AIG, so that it had a lot of short-term liabilities backed by long-term assets. When counterparties for a variety of reasons stopped providing short-term funding to AIG, it was faced with a need to sell long-term assets, and a lot of those assets were mortgage securities whose prices were depressed.

I came away from this analysis believing that the securities-lending program was important. However, I am less convinced that AIG was insolvent or that some of its subsidiaries were insolvent.

The Dismal Forecasting Record

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Tim Harford writes,

There were 77 countries under consideration, and 49 of them were in recession in 2009. Economists – as reflected in the averages published in a report called Consensus Forecasts – had not called a single one of these recessions by April 2008.

… Making up for lost time and satisfying the premise of an old joke, by September of 2009, the year in which the recessions actually occurred, the consensus predicted 54 out of 49 of them – that is, five more than there were. And, as an encore, there were 15 recessions in 2012. None were foreseen in the spring of 2011 and only two were predicted by September 2011.

He cites research from Prakash Loungani and Hites Amir. Some comments:

1. This underlines the fact that macroeconomists are using equations that are not verified empirically.

2. Perhaps the “target the forecast” mantra of market monetarists would not work as robustly as they might hope.

3. According to the NBER, the U.S. was already well into a recession by April 2008 and already out of recession by September of 2009.

Reform of Macroeconomics Teaching

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Simon Wren-Lewis writes,

So my first point, which I have made before, is that we can get rid of a lot of stuff that is simply out of date. Like the LM curve (and theories of money demand that go with it). And the Aggregate Demand curve which is derived from it. And Mundell Fleming which is an open economy version of it (and inconsistent with UIP to boot). And the money multiplier (which, apart from being very misleading, is unnecessary if we stop fixing the money supply).

That is fine. But he winds up with this:

So there you have it. Econ 101 with just three basic relationships: an IS curve, a Phillips curve and UIP

Pointer from Mark Thoma. UIP stands for uncovered interest parity, with the impact that a higher interest rate at home is associated with a stronger currency and reduced net exports.

Actually, I do not think that replacing the equations that have gone out of fashion with those that are currently fashionable represents an improvement. Quite possibly, it is worse. As Noah Smith points out, these equations are not empirically verified. They are merely asserted.

I think that macroeconomics ought to be taught as a combination of economic history and history of thought. In that regard, I think that my macro memoir would have some value, although other perspectives also deserve to be included.

Provocative Sentences

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From Roger Pielke:

a “carbon cap” necessarily means that a government is committing to either a cessation of economic growth or to the systematic advancement of technological innovation in energy systems on a predictable schedule, such that economic growth is not constrained. Because halting economic growth is not an option, in China or anywhere else, and because technological innovation does not occur via fiat, there is in practice no such thing as a carbon cap.

Pointer from Mark Thoma.

If you assume a Leontief production function, then this is correct. You either come up with a way to reduce the fixed coefficient of carbon/output or you reduce output.

Instead of a fixed-factor production function, assume some substitutability, in which you can produce the same output with less carbon emissions and more of some of other factor of production–labor, capital, or other forms of energy. That would mean that you can vary the carbon/output ratio with existing knowledge, so that Pielke is not correct. He might argue that the elasticity of substitution is quite small, which may plausibly be the case.

I am skeptical that a carbon cap would be implemented effectively. The more narrowly it is implemented, the more the substitution will be between two different sources of carbon emissions rather than away from overall carbon emissions. Thus, the recent announcement by the EPA that it will target the electric power industry for a 30 percent reduction in emissions over a period of decades strikes me as unwise from even the most staunch environmentalist perspective. Assuming that the policy were to stick and the reduction were to be achieved within that industry, it would most likely be the result of a shift of carbon-intensive energy sources to uses in other sectors. It is not hard to picture a scenario in which total carbon emissions actually increase as a result, because you are directing carbon-based energy sources into less efficient uses.

Regardless, the EPA announcement works well as a gesture. And politics seems to be mostly about gestures. In Hansonian terms, politics is not about policy.

Employment and ACA

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Casey Mulligan writes,

the ACA will put millions of workers in the economically extreme situation of having zero short-term financial reward (or less) to working full-time rather than part-time.

In economics jargon, this means the ACA creates marginal tax rates on labor income that exceed 100 percent.

The SNEP solution might be as follows:

1. Re-orient health financing policy toward catastrophic health insurance and health savings accounts. Create a national standard catastrophic health insurance plan that acts like true insurance and is reasonably affordable.

2. Repeal the ACA.

3. For non-elderly households with able-bodied adults, replace Medicaid and other means-tested programs with the universal benefit or flex-benefit.

4. For a household without health insurance who receives the flex-benefits, automatically allocate an amount of flexdollars toward health insurance. Perhaps the first $1500 per person in a household would go toward a combination of health insurance (which could be the national standard catastrophic plan) and a health savings account.

5. Close to half of current Medicaid spending is on the elderly and the disabled. I do not think that the flex-benefit system deals with those groups. At this point, I do not see a better approach than Medicaid in those cases.

This would create something like universal health insurance coverage, but with an emphasis on real insurance rather than Medicaid or pre-paid health plans. It also would get rid of the problem of high marginal tax rates. Thus, it would be better than the ACA in both dimensions–there would be fewer households without health insurance and fewer households facing strong disincentives to work.

Financial Stability, Regulation, and Country Size

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Lorenzo writes,

Something that is very clear, is that “de-regulation” is a term empty of explanatory power. All successful six have liberalised financial markets–Australia and New Zealand, for example, were leaders in financial “de-regulation”. If someone starts trying to blame the Global Financial Crisis (GFC) on “de-regulation”, you can stop reading, they have nothing useful to say.

Pointer from Scott Sumner.

The deregulation story amounts to saying that we know that regulation can prevent a crisis, but a crisis occurred, therefore there must have been deregulation. In fact, the risk-based capital rules that I have suggested helped cause the crisis were at the time they were enacted viewed as regulatory tightening, to correct flaws in the regime that existed at the time of the S&L crisis. The deregulation that did take place was intended to reduce bank profits by making the industry more competitive, not to increase profits or risk-taking.

Lorenzo’s post mostly beats a drum that I have been beating, which is that government tends to get worse as scale increases. He writes,

It is generally just harder to stick it to folks (either by what you do or what you don’t do) in a way that doesn’t get noticed in smaller jurisdictions. (Unless jurisdictions are so small they fly under the media radar but are big enough to be semi-anonymous–urban local government in Oz has a bit of a problem there.)

How to Fix Infrastructure

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Scott Sumner writes,

I think a better comparison for New York would be a high income, world-class city like Singapore or Hong Kong or Dubai. Those places are able to build very good infrastructure quickly and at low cost. They might use Bangladeshi migrant workers at $1/hour instead of American “prevailing wage” workers at $50/hour. Indeed even cities like Paris and Berlin build new subway lines at 1/7th the cost of the New York project. A small part of this cost gap may be due to physical differences between the various cities, but by no means all of it…

This demonstrates one of the many internal contradictions of American progressivism. (And by the way, American conservatives have just as many internal contradictions.) You can have your strong public employee unions, “prevailing wages” and restrictive work rules, or you can have nice infrastructure. New Yorkers have (perhaps unknowingly) made their choice. Now they must live with the consequences. Few progressives (with the notable exception of Matt Yglesias) understand these internal contradictions.

Economists Heart Banks

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The IGM forum polls responses to this statement:

There is a social value to having institutions that issue liquid liabilities that are backed by illiquid assets.

Not one of the economists polled disagrees.

For mood-affiliation purposes, I would have said “agree.” But I think it is uncertain, only because such institutions seem to always end up codependent with government in ways that detract from social value.

The Prisoner Swap

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I should not comment on this sort of news, but there is nothing else going on right now. [ed. so how about just not posting for a while?] Anyway, this caught my eye.

Todd Sandler, an economist at the University of Texas-Dallas, studied four decades of data and found that, for every kidnapper paid, 2.5 more abductions occurred.

I look at this from a spy-novel perspective. In that case, the American intelligence community might send an American to “wander off,” get captured, pretend to be a deserter, and gather intelligence. When his usefulness has ended, you swap five ex-Taliban for him. Of course, you have convinced those ex-Taliban to spy for you.

Surely, the Israelis only exchange prisoners who they believe will provide them, wittingly or otherwise, with useful intelligence when they are released?

Of course, if the terrorists keep kidnapping Americans and Israelis, that means they either (a) don’t know about the spy-novel stuff or (b) don’t think that Americans or Israelis are that clever/dastardly or (c) don’t mind absorbing new spies, because the publicity from kidnapping and exchanging prisoners helps with fundraising and recruiting.

If I Gave a High School Graduation Speech

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I am going to talk about community service…and why I am against it.

Today, you will see students given awards for community service. I want to explain why I disagree with that.

I think that young people can learn to be good citizens at least as well by day-dreaming, playing, socializing, or working for paying jobs at profit-making enterprises. I am tired of seeing them indoctrinated to believe that only volunteer work for no-profits qualifies as doing good.

We live in a complicated world. Many people try to simplify difficult moral issues by using the shortcut that some of us call the intention heuristic. With the intention heuristic, you say that if your intentions are good, then you are doing good, and conversely. Moreover, most people apply the intention heuristic by saying that non-profits have good intentions while profits are an indicator of bad intentions.

In fact, there are many well-intentioned people involved in profit-making enterprises. And non-profits are hardly free from venality and corruption. But leave that aside. The important point is that in a complicated world intentions do not correlate with outcomes.

If you judge people by how their life’s work contributed to better lives for people and less poverty in the world, then I will gladly stack up the Henry Fords and Thomas Edisons against the Mother Theresas. Collectively, the capitalists and entrepreneurs have a much better claim on our gratitude than do the icons of community service.

What would you rather have in your community? Would you rather have the Wal-mart that hires the workers that other businesses cannot use and for whom politicians can offer no assistance–people with little education or training, including people with disabilities? Or would you rather have the “activists” who fight to keep out Wal-Mart or who insist that they should dictate Wal-Mart’s labor policies?

In a complicated world, good intentions can have terrible consequences. One hundred years ago, many well-intentioned people championed Communism. When Lenin took power in Russia in 1917, he actually believed that the economy would organize itself, and that without profits production would be more efficient and more equitable. When both his ideas and his leadership proved unpopular, he responded with ruthless tyranny. His took his self-righteousness to a mad extreme, but I am afraid that there is a little bit of Lenin lurking among all of those who are so certain that community service is morally superior to business.

If those of you who are graduating today go on to attend a liberal arts college, you will hear constantly from people who equate moral character with political expressions of approval for non-profits and disapproval of business. They judge you not by the content of your character but by the conformity of your political expression. I urge you to reject their doctrines.

If you undertake community service, do so quietly, without righteousness. Do not celebrate community service. Do not give a special place of honor to community service. Above all, do not demean those who serve the community by helping to provide ordinary goods and services through profit-making enterprises. Their community service is honored not by wealthy donors or by doctrinaire teachers. Instead, their community service is honored by ordinary people who voluntarily choose to spend money to obtain what the profit-seekers have to offer. These willing consumers are all the evidence that is needed to show that the occupation of those in business has decent moral worth.