Monthly Archives: October 2015

Specialization and Trade

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Chelsea German writes,

Last week, I wrote about a man who spent 6 months of his life and $1,500 to make a sandwich entirely from scratch, without the benefits of market exchange. The story illustrates how exchange and trade enrich our lives.

After making his incredibly costly sandwich, the same man embarked on an even costlier endeavor: making a suit from scratch. He picked cotton from a field, spun the cotton into thread, wove the thread into cloth, sheared wool from a sheep, harvested hemp, raised silkworms for their silk, killed a deer and tanned its hide to make leather. This process cost him 10 months of work and $4,000.

Pointer from Don Boudreaux.

I just don’t think you capture the phenomenon of specialization and trade with textbook economic models. It is not two-by-two trade. It is far more complex than that. And don’t get my started on representative-agent models of the GDP factory.

Poor Replication in Economics

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Andrew C. Chang and Phillip Li write,

we replicate 29 of 59 papers (49%) with assistance from the authors. Because we are able to replicate less than half of the papers in our sample even with help from the authors, we assert that economics research is usually not replicable.

Pointer from Mark Thoma.

As an undergraduate at Swarthmore, I took Bernie Saffran’s econometrics course. The assignment was to find a paper, replicate the findings, and then try some alternative specifications. The paper I chose to replicate was a classic article by Marc Nerlove, using adaptive expectations. The data he used were from a Department of Agriculture publication. There was a copy of that publication at the University of Pennsylvania, so I went to their library and photocopied the relevant pages. I typed the data, put into the computer at Swarthmore–and got results that were nowhere close to Nerlove’s.

Steve Teles Defends Technocrats

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He wrote,

greater responsiveness only increases the opportunities for concentrated interests to exert influence over the agencies that are supposed to regulate them. Perhaps ironically, it may be the case that only those regulatory agencies that are able to escape domination by politicians will be able to effectively pursue the goals that those same elected officials wrote into law back when the public was paying attention. Effectiveness, in short, may demand a significant degree of bureaucratic autonomy, rather than democratic control.

…Carpenter’s key insight is that bureaucrats themselves have the power not only to shirk or subvert their principals, but in some cases to guide or even dominate them. The canvas on which he explains how this is possible is the history of one of America’s most powerful agencies, the Food and Drug Administration.

Teles is reviewing a book by David Carpenter, in which the author argues that the FDA’s power stems from its reputation. Because the FDA is highly regarded, it can maintain its independence from Congress.

Teles sees that as a good thing. His model of politics is that there are fleeting demands for regulation, to which Congress responds by establishing an agency. However, once the spotlight is off and the actual regulatory process is underway, the more politically responsive the agency, the more likely it is that the agency will be manipulated by special interests. It is better for the agency to polish its reputation and sustain independent power.

In this model, what is it that limits an agency’s power?

In theory, the loss of reputation leads to a loss of power. When has this happened? The Federal Emergency Management Agency (FEMA) has a terrible reputation, but it has at least as much responsibility as ever. Same with the Transportation Security Administration (TSA). The Environmental Protection Agency (EPA) recently spilled chemicals into the Colorado River, and as far as I can tell it suffered no consequences.

Still, I think that it is fair to say that technocrats focus on their reputations. Bad publicity does attract Congressional attention, and perhaps that makes an agency less aggressive than it otherwise might be.

But reputation-protection, rent-seeking, can be costly. A place like the Fed selects for chairmen who write self-serving memoirs. The question is whether the focus on reputation leads to better behavior or mere image-polishing.

In the private sector, there is the same tension. Reputation can be earned, or it can be manipulated through public relations. But one hopes that the competitive process will eventually expose the manipulators and reward the good performers.

Two Stars for Shaky Ground

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For the first time in many years, I wrote a review for Amazon. About Bethany McLean’s book on Freddie and Fannie, I say,

I was disappointed with this book, because I think that her earlier work, All the Devils are Here, co-authored by Joe Nocera, is probably the best journalistic account of the run-up to the financial crisis.

On “Shaky Ground,” here are my thoughts:

1. This book might have been titled “Sympathy for the Devils.” There is way too much sympathy expressed for the hedge funds that bought preferred stock in Freddie and Fannie. They were making a bet that the political process would come out a certain way, and they lost that bet, fair and square. End of story, as far as I am concerned. I should note that on several occasions representatives of the hedge funds have felt me out about doing some “research” or writing an article to support their position. I would not have done it for any amount of money. I am not accusing McLean of having succumbed to this, but I would not completely rule it out.

2. The other devil who gets a ton of sympathy is former Fannie Mae executive Tim Howard. McLean endorses all of his self-serving views, which include a claim that he did nothing wrong in Fannie’s giant accounting scandal. Also, his view is that had the Fannie management not been replaced, his team would have averted the crisis. Both claims may be true. In my opinion, Freddie and Fannie were better managed before both of their management teams fell in accounting scandals. But I think that more journalistic skepticism is in order. Regardless of who was in charge, there was pressure on Freddie and Fannie management to dive into high-risk lending, with shareholders seeing profits and regulators seeing a mission to expand home ownership opportunity.

3. She is no fan of Ed DeMarco, who was the only person in Washington working to gradually wind down the GSE’s, which is supposedly what everyone wanted. I think it is fair to say his approach was too unpopular with key players to be sustained. But he does not deserve to be dismissed by McLean with boo-words, like “free-market ideologue.”

4. She says that if you take it as given that the government is going to promote what the housing lobby wants, namely “home ownership” with little actual equity and a mortgage market dominated by the 30-year fixed-rate loan, then keeping Freddie and Fannie is better than the alternatives. If you accept the premise, then I agree. But there is a powerful case to be made against government caving into the housing lobby. The costs of this, including serial financial crises (the S&L crisis, the crisis of 2008) and misallocation of capital, are huge, and the social benefits are miniscule. (The private benefits can be enormous–just ask Tim Howard.) McLean does mention some of the evils of this housing-industrial complex, but her bottom line is, in effect “you can’t beat ’em, so don’t try.”

Overall, this is not a terrible book. But if you read it, you should keep in mind that she gives the most favorable treatment possible to Freddie, Fannie, the hedge fund investors, and to policy makers who attempt social engineering using housing finance. Although the book is not completely one-sided, she does not give alternative points of view as much respect as I think they deserve.

The Fed as a Bank

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A commenter asks,

1) Suppose the Fed increased interest on reserves from 0.25% to 8% tomorrow and simultaneously began a program to sell few trillion of the assets on it’s balance sheet and announced a new inflation target of 0%. What does the Book of Arnold predict will happen to inflation over the next two years?

2) Suppose the Fed cut the interest rate on reserves to -2%, announced a plan to buy an unlimited amount of financial assets until a market based forecast of NGDP 5 years from now reached $22.5T (5% year over year growth). What does the Book of Arnold predict will happen to NGDP over the next two years?

I think of the Fed as a bank. It makes profits in a weird way. It requires banks to hold reserves, and then it imposes a tax on those reserves by paying a below-market interest rate. Funded this way, it buys assets that earn a market rate of interest. (The Fed also profits from assets obtained with zero-interest-rate currency.)

So in the first exercise, the Fed’s cost of funds would rise from 0.25 percent to 8 percent. If this were to happen to any bank, it would soon be insolvent. For the Fed, this would mean having to go to Congress and beg for a large appropriation to cover its losses. That is such a weird and unlikely scenario that I do not think that any prediction can be made about NGDP.

In the second exercise, the higher tax on bank reserves would make their business less competitive, perhaps even unprofitable. We could see a big decline in bank balance sheets and an increase in shadow banking, or maybe just an increase in reserve-minimization tactics, like sweep accounts. Because reserves would plummet, the Fed’s liabilities would shrink, not rise. The only way that the Fed could expand its balance sheet would be by using currency to pay for its increase in assets.

I am not sure what the net effect would be on nominal GDP. Perhaps in the short run, you get bank failures and other forms of financial disruption, causing actual and forecast nominal GDP to decline.

The phrase “buy an unlimited amount of financial assets until…” makes me want to draw a cartoon with Janet Yellen telling investors “we will administer an unlimited amount of beatings until morale improves.” Again, I wonder how much the Fed could actually buy before running afoul of Congress.

Look, if you get rid of any constraints on the size and maneuverability of the Fed, then sure, they can do something to nominal GDP. And if you get rid of any constraints on the size and maneuverability of my body, then I could play in the NBA.

Recycling is Not Sustainable

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John Tierney writes,

Despite decades of exhortations and mandates, it’s still typically more expensive for municipalities to recycle household waste than to send it to a landfill. Prices for recyclable materials have plummeted because of lower oil prices and reduced demand for them overseas. The slump has forced some recycling companies to shut plants and cancel plans for new technologies. . . .

Moreover, recycling operations have their own environmental costs, like extra trucks on the road and pollution from recycling operations. Composting facilities around the country have inspired complaints about nauseating odors, swarming rats and defecating sea gulls. After New York City started sending food waste to be composted in Delaware, the unhappy neighbors of the composting plant successfully campaigned to shut it down last year.

Belongs on first-year economics course reading lists everywhere.

Bethany McLean Slips

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In her new book, Shaky Ground: The Strange Saga of the U.S. Mortgage Giants, she writes,

Originally, Fannie and Freddie owned the mortgages they purchased. but over time, as the capital markets in this country evolved, Fannie and Freddie began to package up the mortgages they purchased, stamp them with a guarantee. . .and sell them as securities to investors.

This is true of Fannie. But for Freddie the history is the opposite. They were in the securitization business from the beginning in 1970, and only around 1990 did they start to hold a substantial share of mortgages and mortgage securities as assets. There were several reasons that Freddie shifted to holding a large portfolio, funded by debt.

1. By 1990 Freddie was a shareholder-owned company (before that, they were basically a government agency), and shareholders were interested in profits. Having a large portfolio was profitable.

2. Prior to that, Freddie was concerned about the risk of holding mortgage portfolio. If you fund with short-term debt and interest rates rise, you end up paying more in interest expense than you earn on mortgages. If you fund with long-term debt and interest rates fall, borrowers refinance at lower rates and you are stuck with the high long-term debt costs. But Fannie Mae found a solution, which consisted of issuing callable debt. For example, they might issue a 10-year bond that can be called in 5 years. The market charged a surprisingly low interest rate on such securities, so Freddie started issuing them. Combining callable debt with some interest-rate derivatives gave Freddie and Fannie something close to an arbitrage profit in portfolio lending. They were helped, of course, by their “too big to fail” status, which made investors treat their debt as risk free–until the summer of 2008.

Anyway, I am sorry McLean slipped up on this. I really liked her book with Joe Nocera, All the Devils are Here, and I still have high hopes for her new one, which I have just started. I expect to post more on it.

I found this interesting:

When they were taken over, Fannie and Freddie had a combined $5.3 trillion in outstanding debt,, which, had it been put on the government’s balance sheet, would have increased the public national debt by about 50 percent. Partly to avoid that, the government left 20.1 percent of Fannie’s common stock, as well as other securities known as preferred shares, in the hands of investors.

Fannie and Freddie were originally government agencies. Fannie was privatized not for ideological reasons, but because Lyndon Johnson wanted Fannie’s debt off the government balance sheet. He was trying to fund the Vietnam War, plus the war on poverty, and he did not want Congress bothering him with debt-ceiling issues.

So here we were in 2008, and Fannie and Freddie should have been re-nationalized, but once again, the cosmetics of the government balance sheet took precedence.

Lifted from the comments

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Handle, who is a popular commenter here, wrote a long essay on this post.

I’ll start with my outline/interpretation of Handle’s comment, and then reproduce the comment.

1. Political movements need to coordinate. This requires simplifying messaging. (This may explain why my three-axes model seems to work. While there may be all sorts of subtle nuances to individuals’ thinking, it is easiest for progressives to signal to one another by invoking the oppressor-oppressed axis, or for conservatives to signal using the civilization-barbarism axis, or for libertarians to signal using the freedom-coercion axis.)

2. In a complex world, this sort of simplification can have adverse consequences if one group becomes dominant and tries to cram every issue into its simple framework. We are better off in a society where no one ideological framework takes over.

3. However, the progressive movement seems dominant today. The more that the progressive agenda becomes implemented, the more damage it will cause. Paradoxically, this will lead progressives to become more adamant and less tolerant of dissent.

If you combine Sanders and Warren, what you get is socialism combined with demonization and intimidation of anyone who does not support left-wing views. This is the country that the Democratic left wants to live in?

I take this as a rhetorical question to try and make mainstream elite democrats, who would not be comfortable admitting that they side with Socialist bullies, a little ashamed of not speaking up against them and of belonging to a party increasingly characterized by those types of characters and behaviors.

However, I think the accurate and unfortunate answer is ‘yes’ for a good portion of Democrats, and the reasonable, enlightened and moderate folks for whom the answer is ‘no’, still have no desire or ability to resist it.

Which raises the question as to why that should be, which I think is the most important question about social-psychological dynamics of our era, especially since it could give us some insight into how the near future will unfold.

Please allow me to speculate a little on it. Continue reading →

Cinnabonomics

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I review the latest book by George Akerlof and Robert Shiller. I generally admire both authors. Ordinarily, if I do not like a book, then I do not write a long review. However, because both authors are Nobel Laureates, and because the book has received some positive press, I made an exception and let go with both barrels.

The authors do not deny that markets often work. However, if phishing equilibrium is limited to specific types of products, then the authors do not say so, nor do they give any criteria or characteristics to look for in order to predict in which markets phishing equilibria will be most prevalent.

But you have to read to the whole review to get the flavor.

Recall that Alex Tabarrok did not much are for the book, either.

Research with Pre-commitment

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Kimberly G. Noble writes,

In a study published this year in Nature Neuroscience, several co-authors and I found that family income is significantly correlated with children’s brain size — specifically, the surface area of the cerebral cortex, which is the outer layer of the brain that does most of the cognitive heavy lifting. Further, we found that increases in income were associated with the greatest increases in brain surface area among the poorest children.

…I am part of a team of social scientists and neuroscientists planning a large clinical trial in which 1,000 low-income mothers will be randomly assigned to receive either a large ($333) or small ($20) monthly income supplement for the first three years of their children’s lives. Periodic assessments of the children and their mothers will enable us to estimate the impact of these cash supplements on children’s cognitive, emotional and brain development, as well as the effect on family functioning.

…Our clinical trial is designed to provide strong evidence regarding whether and how poverty reduction promotes cognitive and brain development. This study, however, will take at least five years to complete — far too long for young children living in poverty today. We should not wait until then to push for policies that can help inoculate young children’s pliable brains against the ravages of poverty.

Pointer from Mark Thoma.

Her policy suggestions seem to me to be based quite a bit on emotion, and some of them do not even (to me) seem related to children’s brain development. This makes me concerned that perhaps she is so emotionally attached to her preferred policy solutions that she is pre-committed to finding that poverty causes small surface area of the cerebral cortex, rather than finding that the correlation comes from income and brain characteristics being correlated between parents and children. This my be an example of a study where only a positive finding will be published; a null finding may never see the light of day.

I am glad that she wants to do a controlled experiment. If the results come out the way she would like, then it will be an important finding. I would be happy to volunteer to help audit the study.