Good Turner, Bad Turner

In Between Debt and the Devil, Adair Turner writes (p. 61),

Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment…But in most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and above all, existing real estate.

…Different categories of credit perform different economic functions and have different consequences. Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable. Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt.

What is good about the book is that he invites us to examine how credit is created and where it goes. As he points out, standard macro models have totally ignored this issue.

What is bad about the book is embedded in the last sentence quoted above. We are left to assume that the huge allocation of credit toward housing was the operation of “free market forces.” I do not know about other countries, but for the United States this is totally false. The government was very much involved in channeling credit, and it channeled as much as it could toward housing finance.

Still, I think that what is good about the book makes it worth reading. I plan to say more when I have finished it.

Trying to Reconcile These

As you know, bakers who would not bake a wedding cake for a gay couple ran afoul of the legal system. Now, we find that Muslims who would not deliver alcohol were protected by the legal system.

I am trying to avoid the conclusion that the legal system is here to protect people with whom the judge is sympathetic and to punish people with whom the judge is not. So here is my best shot:

1. The trucking company that fired the Muslim workers had many alternatives. They could have easily accommodated the wishes of the Muslim workers and still delivered the beer. Firing the Muslim workers for not delivering beer was equivalent to firing an observant Jew for not working on Saturday.

2. For the gay couple, however, there was close to no alternative but to go to this particular bakery for a wedding cake. By refusing to bake for this couple, this bakery was forcing the couple to either forego a cake, pay a high price to a different baker, or travel far to obtain a cake.

So if your religious beliefs to do not severely constrain the alternatives of the other party, then your religious beliefs take precedence. If they do severely constrain the alternatives of the other party, then the other party’s needs take precedence.

Does that work? If not, can you come up a better way to rationalize these two decisions?

Oops, Maybe You Should Not Annuitize

Felix Reichling and Kent Smetters write (gated–ungated version here),

But the presence of stochastic mortality probabilities also introduces a correlated risk. After a negative shock to health that reduces a household’s life expectancy, the present value of the annuity stream falls. At the same time, a negative health shock produces potential losses, including lost wage income not replaced by disability insurance, out-of-pocket medical costs, and uninsured nursing care expenses, that may increase a household’s marginal utility. Since the value of non-annuitized wealth is not affected by one’s health state, the optimal level of annuitization falls below 100 percent.

I once wrote,

An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide.

Economists have been preaching for 50 years that the low usage of annuities illustrates a market failure. In fact, what it may illustrate is that economists who relied on a mathematical model left out some important considerations. We need a term for this. I propose model failure.

Trade Facilitation

Timothy Taylor writes,

reforming the legal and regulatory processes around customs, and reducing delays, means that there is less reason to pay bribes to facilitate the process–and thus reduces corruption.

Read the entire post. It takes some nuggets from one of those reports that only Taylor seems to find, the source in this case being the World Trade Organization. The point is that there are many administrative and legal processes that inhibit cross-border trade, and reform of these processes could generate a lot more trade and economic improvement.

Peter Berkowitz on Higher Education

He writes,

As a consequence of the decline of liberal education in the United States, most American Jews will also graduate college without a basic knowledge of the virtues that underlie free societies; the institutional arrangements through which constitutional government secures liberty and equality under law; and the assumptions, operations, and achievements of free markets.

This a symposium on the future of Jews, but his comments apply to the future of well-educated Americans in general. I am afraid to say that

a) I agree with Berkowitz about the way higher education now works, or does not work.

b) I think that unless new institutions emerge that solve this problem, one has to be very pessimistic about the future.

Other contributions to the symposium that I found interesting include that of Eliot Cohen (whose brilliant daughter I taught in high school) and Eric Cohen, who writes,

in the realm of politics, Jews seem pathologically silly…

In America, Jews should be focused on promoting school vouchers, the only hope for expanding the day-school movement and unleashing a new generation of Jewish educational entrepreneurship; on fighting to defend religious liberty, the only hope for ensuring that traditional Jewish beliefs and institutions are not marginalized by a hostile secularist culture; and on electing political conservatives, the only ones who still believe that Jewish nationalism is a noble cause and that American power is necessary to preserve decency and order in the troubled Middle East.

I am quite sure that the phrase starting with “American power” will turn off libertarians, including many Jewish libertarians.

The Year I Beat Bill Gates

Shane Greenstein writes,

Gates misinterpreted the value of the Internet’s commercial prospects. This error would take three interrelated forms in its conventional assessment:

1. Underestimating the Internet’s value to users;
2. Underestimating the myriad and clever ways entrepreneurs and established firms would employ Internet and web technologies to provide that value for users;
3. Underestimating the ability of Internet firms to support applications that substituted for Microsoft’s in ther marketplace.

This is from How the Internet Became Commercial, Greenstein’s new book. I started my business on the Internet in April of 1994. Gates did not become a believer in the Internet until a year later.

Greenstein offers a well-judged analysis of the business strategy and Internet governance issues during the first decade of the Internet’s commercialization, starting in 1994. However, I think that there is still plenty of room for someone to write another book on this historical episode. I would like to see a book that makes the dynamics more vivid.

In the introduction, Greenstein sketches a few timelines on which he lists events. I am not clear whether he chooses the events for their significance or to try and help the reader understand the order in which certain developments occurred. In any case, his choices are mostly very different from what mine would have been.

I actually would include several timelines:

–the release date and processing speed of Intel’s chips. Another would show

–the amount of hard disk storage on a top-selling personal computer each year.

–the speed of the most commonly used Internet connection each year. I remember when 28.8 Kilobytes per second was an upgrade.

–the number of people with Web access each year. When I started my business, unbeknownst to me that figure was less than a million. I had read, correctly, that there were 20 million Internet users in the U.S., and I very naively figured that this was approximately the number of people with Web access. The Web did not become a mass-market phenomenon until the fall of 1995, when AOL began offering Web access and Microsoft released Windows 95.

–the total number of web sites and the top five web sites in terms of traffic each year.

–well-hyped businesses that failed, such as MecklerWeb, Web TV, and PointCast Network.

–buzzwords that no longer have meaning, such as portal and push technology.

–creation of important software and protocols, such as JavaScript, Java, Flash, MP3, JPEG, and Linux.

–appearance of iconic web sites, such as Yahoo, Amazon and Google

–fading of once-iconic web sites, such as AltaVista, the NCSA home page, and the Netscape home page.

–Internet IPOs, by year

My point is that the environment evolved very rapidly. Your business strategy could not be based on what was there at the time. It had to be based on a guess about what was coming.

I describe my business experience in those days as a sequence of miscalculations, because I got so many things wrong. But I made some fundamentally good guesses about what was coming, and that was sufficient.

How Bad is Financialization?

Noah Smith writes,

For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.

Pointer from Mark Thoma.

1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.

2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”

What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.

Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.

Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.

Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.

Another AS-AD Anomaly

Timothy Taylor writes,

[Alan] Krueger argues that the patterns of wage changes and unemployment are roughly what one should expect. He focuses only on short-term employment (that is, employment less than 27 weeks), on the grounds that the long-term unemployed are more likely to be detached from the labor force and thus will exert less pressure on wages. Increases in real wages are measured with the Employment Cost Index data collected by the US Bureau of Labor Statistics, and then subtracting inflation as measured by the Personal Consumption Expenditures price index. In the figure below, the solid line shows the relationship between short-term unemployment and changes in real wages for the period from 1976-2008. (The dashed lines show the statistical confidence intervals on either side of this line.) The points labelled in blue are for the years since 2008. From 2009-2011, the points line up almost exactly on the relationship predicted from earlier data. For 2012-2014, the points are below the predicted relationship, although still comfortably within the range of past experience (as shown by the confidence intervals). For the first quarter of 2015, the point is above the historical prediction.

As an aside, note the particular selection of data series. I am not saying that Krueger is wrong for choosing short-term unemployment, the employment cost index, and the PCE deflator. In fact, I think he shows good taste here. But there are other choices available, and I can think of economists who have defiantly done so, cheered on by other prominent economists.

What I wish to point out is that the relationship as depicted is an anomaly with respect to textbook AS-AD, including both Keynesian economics and Sumnernomics. Timothy Taylor refers to the relationship as a Phillips Curve. However, the Phillips Curve relates nominal wages to unemployment, and the chart shows real wages and unemployment. Although in standard macro nominal wages may rise as the unemployment rate falls, real wages are supposed to move in the opposite direction. In standard macro, aggregate supply is derived from movement along the demand curve for labor. When real wages rise by less than productivity increases, demand for labor rises and output goes up. When real wages rise by more than productivity increases, demand for labor falls and output goes down.

Thus, rather than confirming conventional macroeconomic analysis, Krueger’s chart demonstrates an anomaly. In fact, this is hardly a new anomaly. The procyclical behavior of real wages was something that I had observed when I was in graduate school more than 40 years ago.

Of course, you can modify the Keynesian model to accommodate procyclical real wages. Or, you can find data that you believe demonstrate countercyclical real wages (I think that Sumner would try this latter approach). But that is because Keynesian economics is what I call an interpretive framework. How many anomalies you can tolerate before you discard an interpretive framework is a matter of choice. For me, the AS-AD paradigm has too many anomalies to live with.

The WaPo on Government Workers

One one page, Joe Davidson writes,

[Congressman Paul Ryan] viewed federal employees as a privileged class.

On the facing page, Lisa Rein writes,

A year after auditors documented tens of thousands of federal workers on paid leave for at least a month and longer stretches that exceed a year, close to 100 Department of Homeland Security employees still are being paid not to work for more than a year.

The large number persists even after the Obama administration urged agencies in June to curtail their reliance on what is known as administrative leave, the government’s go-to strategy for dealing with employees facing allegations of misconduct.

While employees stay home, they not only collect paychecks but also build their pensions, vacation and sick days and move up the federal pay scale.

No comment.

John Cochrane on Public Finance

And other things. But on public finance, he writes,

The central goal of a growth-oriented tax system is to raise the revenue needed to fund necessary government spending at minimal distortion to the economy, and in particular minimizing the sorts of distortions that impede the growth process.

This is a very basic statement, and I believe that it would be difficult to come up with a good economic argument against it. What it implies is that using the tax code for social engineering is entirely wrong. Subsidies should be subsidies, not tax credits or tax deductions.

But the implications go further. Poor people face very high implicit marginal tax rates, because of the hard cut-offs on benefit programs. As you know, I favor consolidating all benefit programs into a single flexible benefit taxed at about a 20 to 25 percent rate. Also, taxes discourage work (the payroll tax) and thrift (the corporate income tax and other taxes on capital).

There is still room for disagreement about the trade-off between redistribution through taxation and economic growth. But there are many tax reforms on which economists could agree, politics aside.