The Harm of Government Debt

Tyler Cowen writes,

I worry that the general decline of discretionary government spending may make politics less stable (but also more interesting, not necessarily in a good way). When there is plenty of spending to bicker about, politics revolves around that question, which is relatively harmless. When all the spending is tied up, we move closer to the battlefield of symbolic goods, bringing us back to “less stable and more interesting.” If that is a cause, this trend is likely to spread.

For a longer essay on the way that government borrowing creates political friction, see my essay Lenders and Spenders.

Economists and Greece: Finish the Sentence

Greece will achieve economic success when ____.

My inclination is to feel as unable to complete the sentence as I was the similar sentence about peace in the Middle East. Yet Simon Wren-Lewis writes,

To be able to say intelligent stuff about what is going on at the moment (which you would hope an economics education would enable you to do), you need to know quite a lot of economic theory. A lot of macro of course, but quite a bit of finance, and also at least some game theory. . .And if you want to get into all those ‘reforms’ imposed by the Troika, you need a lot of micro.

Pointer from Mark Thoma.

To be fair, Wren-Lewis is saying that knowledge of these topics is necessary in order to offer opinions on Greece. He is not claiming that it is sufficient to finish the sentence.

I just want to emphasize the extent of our ignorance here. Somebody with legitimate training in mainstream economics could easily argue that the best thing for Greece right now would be to get off the Euro. After all, many mainstream economists, perhaps a majority, would say that it was a mistake for Greece to go on the Euro in the first place. Still, there are many other mainstream economists who would argue that it would be better for Greece to remain in the Euro.

As for supply-side reforms, the economic analysis is the easy part. The hard part is dealing with the historical and cultural baggage of the country.

If you forced me to take my best shot at addressing the historical and cultural baggage, I would be inclined to fill in the sentence with “some time after the government runs out of other people’s money.” But there are many economists who would disagree.

In any case, my prediction is that this will not happen soon. Again, I think that the route by which German money gets to the Greek government will be opaque and circuitous for face-saving reasons, but I expect such an outcome. Note: I gather that Tyler Cowen assesses the situation differently. I think we agree that it is possible to claim a symbolic win and take a substantive loss, we just disagree as to which party is most likely to end up doing that.

George Selgin on Calomiris and Haber

He reviews their book Fragile by Design.

the observed interdependence of states and banks isn’t as deep-seated and inescapable as Calomiris and Haber claim. Consequently, keeping bankers and governments from getting too cozy with one another isn’t quite so difficult as they suppose.

Later, Selgin writes,

they seem unaware of the adverse effects of the “bond-deposit” provisions included in misnamed state “free banking” laws. These provisions allowed banks to issue notes only after tendering eligible securities to state authorities for the ostensive purpose of securing the notes’ holders from loss. Calomiris and Haber (p. 169) note that, by making their own bonds eligible for this purpose, states were able to force banks to lend to them “in exchange for their right to operate.” Still they fail to point out that some states force-fed their banks, not “high-grade” bonds (ibid.) but junk ones, and that it was this practice, rather than unit banking, that was the main cause of bank failures during the so-called “free banking” era

…In Canada, in contrast, banks’ almost unrestricted ability to issue notes
contributed to the banking system’s stability no less than banks’ branch networks did.

You may also wish to read my review of the book.

I Disagree with Brad DeLong

He writes,

Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Pointer from Mark Thoma.

These are ultra-Keynesian treatments of the financial crisis and its aftermath. The all-purpose causal variable is a glut of savings and a dearth of government spending.

I cannot prove that this view is wrong. However, I am more convinced by Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. The easiest way to summarize the book is that (with a nod to a different Kraus) risk-based capital regulations were the disease that they purported to cure.

The Friedman-Kraus story is one in which regulators suffer from the socialist calculation problem. With risk-based capital regulations, regulators determined the relative prices of various investments for banks. The prices that regulators set for risk told banks to behave as if senior tranches from mortgage-backed securities were much safer than ordinary loans, including low-risk mortgage loans held by the bank. The banks in turn used these regulated prices to guide their decisions.

In 2001, the regulators outsourced the specific risk calculations to three rating agencies–Moody’s, S&P, and Fitch. This set off a wave of securitized mortgage finance based on calculations that proved to be wrong.

Friedman and Kraus challenge the basic mindset not only of DeLong but of 99 percent of all economists. That mindset is that the socialist calculation problem, if it matters at all, only matters for full-on socialists, not for regulators in an otherwise capitalist system. In the conventional view, regulators can fail for ideological reasons, or because they are manipulated by special interests. But Friedman and Kraus offer a different thesis. When information discovery is vital, regulators, like socialist planners, are doomed to fail because they are unable to mimic the market’s groping, evolutionary approach to learning.

In Friedrich von Hayek’s Nobel Lecture, The Pretence of Knowledge, he concludes,

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society–a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

What Friedman and Kraus claim is that well-intended but now well-informed bank regulations were the destroyer, not of an entire civilization, but of a financial system. Like Hayek, they offer a profound critique of mainstream thinking. Like Hayek, they are sadly likely to be ignored.

529: Popular != Good Policy

Peter Suderman writes,

this episode and the swift bipartisan opposition it generated is so revealing, not only about the short term political instincts of the Obama administration, but about the longer term political and policy dynamics of sustaining the welfare state.

He is writing about President Obama’s proposal to tax savings from “529 plans” for college saving, which the Administration has since backed away from. I read Suderman as saying that the larger point is that when it comes to unsustainable fiscal policy, we have met the enemy and he is us. My comments:

1. Re-read Lenders and Spenders. Government debt inevitably leads to political strife.

2. 529 plans are regressive. Nearly all of the benefit flows to people with high incomes.

3. 529 plans are yet another enabler for colleges to boost tuitions.

4. 529 plans subsidize affluent people for doing what they would have done anyway–send their kids to exclusive, high-priced colleges.

529 plans are terrible public policy. Instead of demagogically criticizing the Administration’s proposal to tax them, I would say let’s get rid of them altogether.

How to Live Beyond Your Means

1. The WaPo reports,

Today, they struggle under nearly $1 million in debt that they will never be able to repay on the 3,292-square-foot, six-bedroom, red-brick Colonial they bought for $617,055 in 2005. The Boatengs have not made a mortgage payment in 2,322 days — more than six years — according to their most recent mortgage statement. Their plight illustrates how some of the people swallowed up by the easy credit era of the previous decade have yet to reemerge years later.

Living rent-free in a $600,000 house is a “plight” only in the sense that at some point you may have to stop.

2. John Cochrane relays,

80% of Greek debt is now in the hands of “foreign official.” Now you know why nobody is worrying about “contagion” anymore. The negotiation is entirely which government will pay.

I must be really old-fashioned or something. But paying taxes so that Greek governments can live beyond their means or that people can live in houses twice the size of mine rent-free is not really my idea of “the things we all do together.”

PG County Foreclosure Story Focuses on the N-word

This WaPo story is long, but nonetheless incomplete.

Using court and land records, The Post analyzed 173 home purchases in Fairwood that wound up in foreclosure between 2006 and 2008.

In 43 of those home purchases, borrowers financed 100 percent of the cost of the home with loans that had high interest rates and reset periods within three years. The loans were of the type that Angelo Mozilo, the CEO of defunct subprime lending powerhouse Countrywide Financial, had called “toxic” because they offered such onerous terms. He warned his own company in internal e-mails that the loans were “the most dangerous product in existence.”

Nearly all the remaining loans The Post examined contained features associated with high default rates, such as low or no down payments, interest-only payment periods and higher rates than prime loans.

Only seven out of the 173 defaulters received the most favorable lending terms, known as conventional 30-year fixed interest rate loans. These “prime” loans are the least likely to fail, experts agree.

The neighborhood is described as primarily African-American, with a median income over $170,000.

Some questions that I have:

1. Why were so many loans made with zero down payment? If the median family income is that high, should there not have been higher down payments?

2. If the borrowers put nothing down to begin with, then foreclosure cost them nothing in terms of lost equity. Presumably, if they were affluent before, they are still affluent now. If not, why not?

3. Did anyone benefit from making these loans? The companies that ended up owning the mortgages took huge losses (taxpayers also may have been involved in some way, through bailouts). Companies that originated subprime loans but did not hold them (the “originate to distribute model”) picked up some small fees, but my guess is that they competed away a lot of profits by incurring marketing costs, and in any case enough of them went out of business that you can hardly envy their franchises.

4. When did borrowers start to fall behind on their payments? If it was within a year of buying the home, then you can be sure that even if the borrowers had gotten prime, thirty-year fixed rate loans they still would have defaulted.

Remember, it was the WaPo that said on January 1st that “narrative” is “out” and “facts” are “in.” Their story is instead all about narrative (the N-word, as I call it), and I think it could use more facts.

Yanis Varoufakis talks with Russ Roberts

He says,

You and I would not be talking about Greece today if Greece in 1999 by some miracle of politics and rationality had stayed out of the Eurozone. That is the reason why it is such a disaster; and it’s why it’s so significant in the world economy and pipsqueak Greece has been dominating for three years. The headlines of [?] which is a sign that something is definitely wrong with the international economy. And the reason for that was that Greece was in the Eurozone. The tragedy of course is once you are in, you can’t get out. You are trapped. And so on and so forth.

The podcast is a year old. It is of interest now because he is now finance minister of Greece.

What’s In Alexis Tsipras’ Wallet?

He is soon to be the Greek premier. The Independent reports,

A Syriza government would have to rely on taxes but tax revenues are down as people wait to see if taxes will be reduced by the new government. This means that Greece may only have the money – though this is disputed by Syriza leaders – until the end of February to pay state employees and pensions and service the debt.

As a far leftist, we can presume he wants to spend lots of other people’s money. Where can he get it?

1. Greek taxpayers. Greece actually was supposed to run a primary surplus this year, meaning that they would only have to borrow to pay interest on debt, not to fund ordinary spending. But apparently the Greek taxpayers do not see it that way. UPDATE: Tony Yates points out a problem even if you have a primary surplus and decide to blow off the interest on your debt. (pointer from Mark Thoma),

the Greek government does not have the funds to stand behind its own banks. They would be left insolvent by a Greek default [economically, they are already, really]. A run on Greek banks, either prompted by default or the threat of it, could not be stemmed by a credible guarantee of deposits.

2. Non-bank investors willing to invest in Greek bonds. Considering that Tsipras does not sound particularly eager to pay off such investors, they might be a bit shy.

3. Banks willing to invest in Greek bonds, since those bonds carry zero risk (according to capital regulations). Still, I can imagine that bank managers are a tad worried that the regulators who designated sovereign debt as risk-free don’t actually have any money with which to back that up.

4. The European Central Bank, which just announced a big “quantitative easing” program, so it needs stuff to buy. The question is how eager Germany and other European countries are to be Tsipras’ sugar daddies.

Pointers in (1) and (4) from Tyler Cowen. Possible outcomes, in order from highest probability to lowest:

1. Eurocrats devise a new elaborate shell game under which they funnel money from other countries to Tsipras while pretending not to do so, hoping that ordinary voters in those countries will not notice, or that even if people notice they will be powerless to do anything about it.

2. The European central bank goes ahead and buys bonds from Tsipras, because the alternative is scarier.

3. Tsipras ends up implementing austerity, because his wallet is empty.

4. Tsipras ends up printing a new Greek currency, as Greece exits the Euro.

What I am Reading

1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).