The Courage to Desist

Robert Shiller writes,

I wrote with some concern about the high ratio in this space a little over a year ago, when it stood at around 23, far above its 20th-century average of 15.21. (CAPE stands for cyclically adjusted price-earnings.) Now it is above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.

Pointer from Mark Thoma. Here is my take:

1. I think investors look at the zero interest rate on short-term money-market instruments and say, “I can’t possibly settle for that.” As they reach for yield, long-term interest rates fall.

2. At low interest rates, long-term bonds become very speculative investments. A small decline in market interest rates, and the market value of your bonds shoots up. Conversely, it takes only a small increase in market interest rates to create a negative return on a bond mutual fund (holding the actual bond rather than a bond fund avoids marking your losses to market, but on an opportunity-cost basis, an actual bond still gives you a negative return in a rising-rate environment.)

3. If Shiller is right and stocks are over-priced, your best strategy may be to sit on those low-yielding short-term instruments and wait for prices to come down. This is hard to do. It is my strategy in fantasy baseball auctions–watch the first 50 players get chosen at prices that I think are too high, and then wait for prices to come down. If prices are too high early, this has to work, because the fixed budgets given to owners mean that prices have to come down eventually. I am not saying you win a fantasy league that way, because luck tends to dominate any advantage you might appear to gain in the auction. But if you wait, you can get good value cheap. I think that we are in that type of stock market.

4. Having said that, we know that for every credible theory that stocks are over-priced there must be an equal and opposite theory that they are under-priced. (See Brad DeLong’s response to Shiller. See also this comment that Tyler Cowen found on his blog) Otherwise, prices would not be as high as they are. The thing is, most of the movement in stock returns is due to changes in the taste/toleranace for risk, and there is no guarantee that this parameter will head toward one particular value.

Related: James Hamilton on the San Diego public employee pension fund reaching for yield.

Universal Basic Income, zero marginal tax rate

Ed Dolan writes,

a UBI would be administratively efficient and unobtrusive. It would require no verification of any personal trait or behavior…If the UBI were integrated into the existing federal income tax system, only households with no income at all would receive the full UBI benefit in cash. Those with low-to-moderate incomes would receive part of the benefit as a credit toward income and payroll taxes, and the rest in cash. Those with high incomes would get a tax credit

Pointer from Mark Thoma.

A universal benefit with a zero marginal tax rate is expensive. Dolan says that we could replace $500 billion in means-tested programs, but that only allows for a benefit of around $1600 per person. Next, he proposes eliminating important middle-class tax deductions, including not only the mortgage interest deduction but the IRA deduction and the personal exemption (!), bringing the benefit up to $5200 per person.

Dolan would exempt current social security recipients from the UBI, so that allows $5800 for the remaining UBI-eligibles.

I still prefer the solution of a benefit with a marginal tax rate of something like 20 percent or 25 percent. I also think that having a benefit that only can be spent on “merit” goods–food, shelter, health care, and education–makes some sense. However, I am open to the argument that administrative costs would detract from the approach of trying to limit the benefit to merit goods.

UPDATE: Commenting on Dolan’s piece, Timothy Taylor warns,

The U.S. political system does not excel at replacing complexity with simplicity, and then leaving well enough alone.

When to Kill the Export-Import Bank?

Paul Krugman writes,

under current conditions mercantilism works – so this is exactly the moment when ending an export-support program really would cost jobs.

Pointer from Mark Thoma.

I say that the right time to kill it is any time you can.

If killing the Ex-Im bank is tea-party mischief, then I say let’s have more such mischief.

The AEI’s Tom Donnelly writes,

The worst thing about the defense loan program is that it only applies to our richest and best allies – NATO Europe, Israel, Japan, South Korea, the ones who can most afford to finance arms purchases on their own – and does nothing for real at-risk states in Africa, Latin America or the Middle East. The FMS-DELG duo has hampered, not helped the Pentagon’s security “partnering” efforts. In today’s environment, and particularly when China aims to replace Russia as the alternate, non-US source of front-line military equipment, the United States government needs a bigger, better and more aggressive export credit agency. The Congress should rejuvenate, not exterminate, the Ex-Im Bank.

His case for the Export-Import Bank speaks for (i.e., against) itself.

Who Wrote These paragraphs?

What other tribe will tell the Fed how to set interest rates, or Congress when to spend money? Mainstream macro has its discontents, but the more time you spend among the people pushing the alternatives, the more you realize how much lesser of an evil the mainstream academics represent.

Check your answer.

We have no business throwing applied-math majors into an economics Ph.D. program. Both a liberal arts mora-philosophy B.A. or equivalent and two years out in the real world working at a job of some sort should be required.

We have no business offering a narrow economics B.A. at all. At the undergraduate social-science level, the right way of organizing a major curriculum is to offer some flavor of history and moral philosophy: enough history that students are not ignorant, enough sociology and anthropology that students are not morons, and enough politics and philosophy that students are not fools. (And, I would say, a double dose of economics to ensure that majors understand what is key about our civilization and do not get the incidence of everything wrong.)

…A first-rate undergraduate economic major will also spend due time on government failure and bureaucratic failure, and thus reach the very economic conclusion that there are substantial trade-offs, and we must pick our poison among inadequate and imperfect alternatives, even in institution design.

Check your answer.

Pointers from Mark Thoma. Some thoughts on why there is such a focus on math.

1. Some economists really believe that the answers can be found inside equations.

2. Some economists (I think of Robert Hall) think that mathematical ability provides a reliable signal of overall intelligence, while other indicators are all more noisy.

3. It is a stable, self-perpetuating equilibrium. Once the math guys took over, they just keep giving the best jobs to other math guys.

4. Important questions in economics tend to have messy, ambiguous answers. Therefore, economists who do a bad job at answering important economic questions, or who do not even bother asking important economic questions, can do quite well for themselves.

5. Graduate students think that a class where the professor explains equations provides tangible training, while a class where a professor poses philosophical issues does not.

Reform of Macroeconomics Teaching

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.

Regulatory Arbitrage Uber Alles

Mark Thoma points to an essay by Dean Baker accusing airbnb, uber, and other services of cashing in on regulatory evasion as opposed to the Internet or other economic fundamentals. Thoma comments,

Agree about the level playing field, but perhaps it will serve as a catalyst for changing regulations that “were originally designed to serve narrow interests and/or have outlived their usefulness”?

Or a catalyst for encouraging the incumbents to act differently. The original low-cost bus services between NY and DC ultimately spurred the legacy bus companies to set up low-cost subsidiaries in order to compete.

In Debt to Social Engineering

Ryan Avent writes,

What is needed, they argue, is to make debt contracts more flexible, and where possible, replace them with equity. Courts should be able to write down the principal of mortgages as an alternative to foreclosure. They recommend “shared-responsibility mortgages” whose principal would decline along with local house prices. To compensate for the risk of loss, lenders, they reckon, would have to charge a fee equal to 1.4% of the mortgage, or receive 5% of any increase in the value of the property.

Pointer from Mark Thoma. “They” are Mian and Sufi, in House of Debt. Avent argues similarly that student loans should have an equity component.

What these forms of bad debt have in common, in my view, is that they reflect clumsy social engineering. Public policy was based on the idea that getting as many people into home “ownership” with as little money down as possible was a great idea. It was based on the idea of getting as many people into college with student loans as possible.

The problem, therefore, is not that debt contracts are too rigid. The problem is that the social engineers are trying to make too many people into home “owners” and to send too many people to college. Home ownership is meaningful only when people put equity into the homes that they purchase. College is meaningful only if students graduate and do so having learned something (or a least enjoyed the party, but not with taxpayers footing the bill).

As long as we still have these sorts of public policies, monkeying around with the nature of the loan contract is simply doubling down on clumsy social engineering.

Larry Summers on Piketty

Mark Thoma seems to have provided the first pointer, although others surely will follow.

Summers’ review is the most complete evisceration of Piketty’s economics that has been published to date. But Summers suggests that we sniff the rose, never mind the manure that lies underneath. He writes,

Even in terms of income ratios, the gaps that have opened up between, say, the top .1 percent and the remainder of the top 10 percent are far larger than those that have opened up between the top 10 percent and average income earners. Even if none of Piketty’s theories stands up, the establishment of this fact has transformed political discourse and is a Nobel Prize-worthy contribution.

This is reminiscent of Brad DeLong. It strikes me as intellectual charity driven by ideological sympathy. I encourage everyone reading this blog to do the opposite. Reserve your most charitable interpretations for those whose views disturb you, and adopt the most critical-thinking posture toward those whose views please you.

The bulk of Summers’ review consists of just this sort of critical thinking. Summers writes,

Piketty argues that the economic literature supports his assumption that returns diminish slowly (in technical parlance, that the elasticity of substitution is greater than 1), and so capital’s share rises with capital accumulation. But I think he misreads the literature by conflating gross and net returns to capital. It is plausible that as the capital stock grows, the increment of output produced declines slowly, but there can be no question that depreciation increases proportionally. And it is the return net of depreciation that is relevant for capital accumulation. I know of no study suggesting that measuring output in net terms, the elasticity of substitution is greater than 1, and I know of quite a few suggesting the contrary.

I have not seen this point about the confusion of gross and net return made by anyone else. By DeLong’s standards, that means we should dismiss Summers’ argument. But to my eye, it seems like a powerful criticism. [UPDATE: Oops! A commenter points out that Matt Rognlie had made the exact point about gross and net return.]

Remember the scandal over the Reinhart-Rogoff spreadsheet? This strikes me as considerably worse.

Summers also writes,

Rather than attributing the rising share of profits to the inexorable process of wealth accumulation, most economists would attribute both it and rising inequality to the working out of various forces associated with globalization and technological change.

As in the Smithian theory of inequality.

The Political Economy of Big Banks

David Cay Johnston reviews All the Presidents’ Bankers, by Nomi Prins. He concludes,

But the banks are only big, not strong. Indeed, the “stress tests” to determine if the banks can withstand another financial shock are designed to test only for minor upsets, rigging the game in favor of the Big Six, which all engage in unsound practices, especially trading in derivatives. They remain big because of bad laws and enablers like Geithner and because politicians desperate for campaign donations listen to the pleas of bank owners more than those of customers. So the bankers live in grand style, lavished with subsidies that cost us more than food stamps for the poor. In return for this largesse, the bankers savage our modest savings.

Pointer from Mark Thoma. To me, Johnston’s rhetoric seems over the top, and if all Prin has to offer is rhetoric and conspiracy-mongering, then I see no need to read her book. Nonetheless, if you ask me about the political economy of big banks in this country, I would say that I believe that their profits come from rent-seeking in general and from the too-big-to-fail subsidy in particular. I think that breaking up the big financial institutions would provide a net public benefit.

However, I would caution you that Fragile by Design, by Calomiris and Haber, offers nearly the opposite perspective. For them, it is America’s historical hostility toward large banks, and the consequent fragmentation of banking, that is the original cause of fragility here. I think Prin would have a hard time arguing, as she apparently attempts to do, that concentrated banking has been a feature of the U.S. for over a century, when banking across state lines was all but impossible up until around 30 years ago. The other point in favor of Calomiris and Haber is the stability of Canadian banks, where the big six have a much higher market share than the big six in the U.S.

Brad DeLong is Uncharitable to Piketty’s Critics

This is an example of the sort of writing that I think serves only to isolate the left-wing blogosphere. Brad starts out innocently enough:

Piketty’s argument is detailed and complicated. But five points seem particularly salient:

1. A society’s wealth relative to its annual income will grow (or shrink) to a level equal to its net savings rate divided by its growth rate.

2. Time and chance inevitably lead to the concentration of wealth in the hands of a relatively small group: call them “the rich.”

Pointer from Mark Thoma. Read the whole thing. He then proceeds to heap scorn on Piketty’s critics. He does not cite any criticism of the second point, which is really the heart of the criticism that I have made. I think that many others have criticized point (2), also, but let me just speak for myself.

To reiterate my criticisms:

1. The distinction between capital income and labor income that underlies the forecast for wealth concentration is unrealistic. Most of “labor” income is a return to capital: human capital, social capital, institutional capital, and so on. Much of “capital” income is a return to risk. Brad himself has pointed out that the rate of return on private capital includes a huge risk premium.

2. Several critics (although I believe I was the first) have pointed out that if you believe r is greater than g, then social security is a giant rip-off and should be privatized immediately. Instead, in one of the most disingenuous arguments in the book, Piketty dismisses privatizing social security because of the high risk embedded in capital income. What is disingenuous is that this risk in private investment undermines Piketty’s main thesis.

3. I think it is pretty difficult to reconcile the risk component of investment with a model in which inherited wealth comes to dominate. Instead, given the relatively low rate of return on risk-free assets, my line is that the inheritors shall be meek.

The Capital Asset Pricing Model notwithstanding, it is idiosyncratic risk that makes you rich. People like Bill Gates and Mark Zuckerberg take large idiosyncratic risks that pay off. For wealth to become concentrated into an oligarchy, their heirs will have to invest in ways that outperform future idiosyncratic risk-takers. That strikes me as implausible.

Finally, I have to quote this from DeLong:

To be sure, everyone disagrees with 10-20% of Piketty’s argument, and everyone is unsure about perhaps another 10-20%. But, in both cases, everyone has a different 10-20%. In other words, there is majority agreement that each piece of the book is roughly correct, which means that there is near-consensus that the overall argument of the book is, broadly, right.

If I understand this paragraph, what Brad is saying is that unless a majority of Piketty’s reviewers harp on a particular fault, then there are no faults in the book. That is certainly a charitable approach to assessing someone’s work.

I think that taking the most charitable approach to people with whom you agree and taking the least charitable approach to those with whom you disagree is a path that leads to intellectual isolation.