John Cochrane vs. Financial Intermediation

He writes,

demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.

I suppose Murray Rothbard would have liked this.

My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.

I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.

Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.

The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.

Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.

But Inequality is the Defining Problem of Our Time

Lawrence Kotlikoff writes,

The US fiscal gap now stands at an estimated $205 trillion, or 10.3 percent of all future US GDP. Closing this gap is imperative, and requires a fiscal adjustment of an immediate and permanent 37 percent reduction in spending (apart from servicing official debt), an immediate and permanent 57 percent increase in all federal taxes, or some combination of the two. The necessary size of this adjustment increases the longer it is put off.

The Financial Crisis and Wealth Transfer

Amir Sufi writes (with Atif Mian).

The strong house price rebound in high foreclosure-rate cities likely reflects these markets bouncing back after excessive price declines. But these foreclosed properties are not being bought by traditional owner-occupiers that plan on living in the home. Instead, they have been bought by investors in large numbers.

This is from a new blog spotted by Tyler Cowen, and both of the first two posts are worth reading in their entirety.

The picture that I get is of a pre-crisis economy in which middle- and lower-middle-income households thought they were doing well in the housing market. Then their house prices collapsed. Vulture investors swooped in to buy. Meanwhile, the government bailed out big banks and the stock market boomed. Some folks will credit the Fed for the latter. I don’t, but that is a bit beside the point here.

Net this all out–the sucker bets on housing by the non-rich, followed by big gains by wealthier folks in stocks and in foreclosed houses, and you get a picture of a huge regressive wealth transfer engineered in Washington. Carried out primarily by those who profess to be outraged by inequality.

Labor Force Participation Chartfight

1. John Cochrane presents a chart showing that over the last 25 years, the employment-population ratio tracks the ratio of people aged 25-54 to the total population.

Pointer from Mark Thoma. The chart is from Torsten Slok of Deutsche Bank.

2. John Taylor has a chart showing that the labor force participation rate is several percentage points that which was projected several years ago based on demographics. The chart comes from a paper by Chris Erceg and Andy Levin.

The first chart suggests that most of the decline in the employment/population ratio in recent years is due to demographic changes. The second chart suggests the opposite. How to reconcile the two?

3. And then there is Binyamin Appelbaum:

In February 2008, 87.4 percent of men in that demographic had jobs.

Six years later, only 83.2 percent of men in that bracket are working.

Pointer from Tyler Cowen.

My verdict is that Slok’s chart, referred to by Cochrane, is misleading. Here is the chart:

The way that the two lines are superimposed makes it appear that 2007 was a glorious year of over-employment, and the plunge in the employment-population ratio looks like a reversion to trend. Suppose you were to slide the blue line up vertically so that it just touches the red line at the peak in 2007. That would make the chart look much more like Appelbaum’s, shown below:

Some other issues:

–I suspect that some of the drop-off in employment has occurred among youth, who are outside of the 25-54 bracket that Slok uses.

–Another issue is what you think should have happened outside Slok’s bracket at the other end, namely 55-64 year olds. These are baby boomers, so that their share of the labor market has been soaring. The most likely reconciliation of the two charts is that the baby boomers have been retiring early at rates higher than historical norms.

As far as labor force participation goes, is 55 the new 65? If so, then somebody should trace out what that means for Social Security. Fewer people paying in and more people collecting disability cannot be a good thing for solvency.

Update: Cochrane offers another take, more nuanced.

Crowding Out

Timothy Taylor writes,

Huntley describes the central estimate about the long-run effects of more government borrowing based on the review of the evidence like this: For each additional dollar of government budget deficit, private saving rises by 43 cents, and the inflow of foreign capital rises by 24 cents. Thus, [e]ach additional dollar of deficit leads to a 33 cent decline in domestic investment.

Jonathan Huntley works for the Congressional Budget Office. Taylor links to the full report. I like the way that Taylor explains the issue.

A few remarks:

1. A Keynesian would be quick to note that crowding out varies over the business cycle. When the economy is weak, there is excess saving, and there is no crowding out.

2. Larry Summers’ hypothesis of secular stagnation says that there has not been crowding out for two decades.

3. I have never heard a conservative economist complain about crowding out during a Republican Administration.

4. I have never heard a liberal economist complain about crowding out, ever. Complaining about (3) does not count.

This report comes out at a time in which the CBO has gotten an unusual amount of negative press. See this WaPo story, for example. Some remarks about this:

1. I think it is difficult for journalists or the general public to understand that some economic estimates are more unreliable than others. For example, estimating the cost of a government program is subject to some error, but most of the time you can get in the ballpark. There is more uncertainty about revenue from tax changes, because of behavioral responses, but one can still arrive at a reasonable range of estimates. On the other hand, estimating the macroeconomic impact of fiscal policy (the so-called multiplier) poses a much higher level of difficulty. You need a macroeconomic model. You need to take a position on the theory of monetary offset. When I was invited to give a lunch talk at CBO, I tried to emphasize that the difference between the uncertainty involved in macroeconomic forecasting and analysis on the one hand and the uncertainty in forecast and estimating the cost of a government program is a matter of kind, not just of degree. And I recommended that CBO should do something to emphasize this to the public. The crowding-out analysis is one that I would put in the high-uncertainty category.

2. It disturbs me that the press takes shots at the CBO only when the analysis raises doubts about progressive policies. If you are not going to raise doubts about CBO analysis of the stimulus, which is based on models that by now are far out of the mainstream, then you should not raise doubts about legitimately mainstream analysis of minimum wages, the employment effects of Obamacare, and, yes, crowding out.

3. Progressives who attack the CBO may be seeking a short-term gain in material at a long-term positional cost. Looking ahead a few moves, I do not think it helps progressives if they convince the public to distrust nonpartisan government experts.

Attribution to the Fed

David Beckworth writes,

The figures below document this failure by the FOMC. The first figure shows the 5-year ‘breakeven’ or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market’s forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

He includes several charts. Read the whole thing. If you tell me that the expected inflation rate has declined from 2.72 percent to 1.23 percent, I think that this is somewhat bearish news. But it is not the end of the world.

See also Matt O’Brien‘s reading of the Fed minutes of 2008. It is quite stunning to consider Ben Bernanke’s behavior during September. On the one hand, he participated in the Paulson Panic, supporting TARP and going all out to save the banks. On the other hand he thought that the risks of inflation and recession were relatively balanced. It is consistent with my view of how the Fed looks at the world, which is through the eyes of the big NY financial institutions.

Still, the way I see it, the attempt to attribute the Great Recession to monetary policy seems forced. The people who believe it really believe it. And I cannot tell you that it is absolutely impossible that a small change in expected inflation can send the economy down the toilet. But I think that the human bias to try to find simple, single causes for things is something to correct for here.

Karl Smith’s Question

As reported by Tyler Cowen.

Name the period or event in economic history where we looked backed and said “hmm, money was less important than we thought at the time

Of course, the trend over the past fifty years has been to assign a large role to money in economic history. I believe that this trend in thinking is wrong-headed.

Let me digress for a moment. A few days ago, I watched “Money for Nothing,” a documentary about the Fed that was sent to me to review. On the positive side, I would say that

1. It includes excerpts of interviews with an outstanding and diverse set of experts, including Allan Meltzer, Alan Blinder, and Janet Yellen.

2. Its rendition of the history of the Fed is well done.

On the negative side, I would say that I have never walked away from a documentary feeling satisfied. That is an understatement. Every documentary, regardless of whether I am sympathetic to its point of view, leaves me feeling swindled. I think the format is suited to leaving people with impressions and illusions, not with genuine understanding.

For example, “Money for Nothing” devotes about 15 seconds each to Brooksley Born and Ned Gramlich. If all you knew about them came from this documentary, then you would have not sense of the ambiguity that surrounds their alleged farsighted desire to increase regulation.

Born was fighting an unlikely turf war, attempting to get the dealer markets in financial derivatives to be overseen by the Commodity Futures Trading Commission, which has expertise in a very different area–standardized contracts traded on organized exchanges. Now, if you abolished the dealer market in derivatives and forced them onto an exchange, then you could place derivatives under the CFTC’s jurisiction. First, there has to be a debate over whether or not this is a good idea (in the wake of the crisis, many people think it would be a good idea. I do not.) But if we take as given the existing dealer market, Born’s claim of turf was untenable.

Gramlich was worried about consumer protection issues in mortgage lending. There were a lot of mortgage brokers behaving like old-time car salesmen, always trying to make customers pay more than necessary. As the housing boom accelerated, more and more borrowers were on the lower end of the scale in terms of income and sophistication, and the abuses and exploitation by lenders tended to increase. (Keep in mind, however, that down payments were so low that the bulk of the losses from the crash were born by investors, not borrowers. The phrase “predatory borrowing” is not unjustified.) To the best of my knowledge, what Gramlich was not doing was warning that the whole financial system was vulnerable because of what was going on in mortgage markets.

Also, the issue of how money affects the economy is too deep and controversial to be captured in a documentary. “Money for Nothing” appears to claim that both high interest rates and low interest rates are bad for investment. High interest rates choke off investment, while today’s low interest rates choke off saving–which is supposedly hurting investment. Maybe they do not mean to make the latter claim, but, again, it is a format that lends itself to leaving you with impressions, rather than helping you think through an issue. The documentary does not raise the issue of the distinction between short-term inter-bank interest rates (which the Fed can affect) from other interest rates (where the effect of the Fed is in doubt among many economists). It does not bring up the issue of the “zero bound,” which some economists (not me) make a big deal out of.

Finally, and this gets back to Karl Smith’s question, I think that “Money for Nothing” vastly overstates the Fed’s role in the economy. Going forward, the big issue is fiscal policy. Remember the ad from Hillary Clinton’s campaign for President where she played the role of Santa Claus, handing out gifts to various constituency groups? Well, going forward, given the excess of the government’s promises relative to its ability to pay, politicians are going to be playing a lot less Santa and a lot more Scrooge. That is going to cause a fraying of our politics, which is already taking place.

In the coming drama, the Fed is a bit player. If we end up with hyperinflation, it will be the result of a total breakdown on the fiscal side, in which the monetary authorities are given no choice but to try to meet the government’s revenue needs by collecting the inflation tax. Not the most likely outcome, and even if it were to take place, the fault would not lie with the Fed.

More broadly, my inclination in macroeconomics is to get away from aggregate supply and demand. I think that the obsession with money and the Fed is one huge attribution error. It is human nature to look for simple causes and scapegoats. I think we should lean against that.

So I would like to see us place less blame on the Fed for the Great Depression. I would like to see us assign less blame to Arthur Burns for the inflation of the 1970s and assign less credit to Paul Volcker for ending it. I think that we may be over-emphasizing the role of money in all of these cases.

Karl Smith is correct to imply that over time we have come to assign a greater role to money than contemporaries did at the time. That does not necessarily mean that we are wiser.

Scott Sumner on the Fed Transcripts

He writes,

Note that on the very day of the September 16 meeting, the meeting at which the Fed refused to cut rates due to fear of “high inflation,” the TIPS spreads were showing only 1.23% inflation over the next 5 years, well below target. The Fed should have ignored its own worries about inflation, and instead relied on the wisdom of the crowds. The crowd is not always right, but they are more reliable than the Fed, especially when conditions are changing rapidly. Market participants saw the bottom dropping out of the economy using millions of pieces of highly dispersed information, while the clumsy Fed waited for macro data that comes in with long lags.

The idea of relying on market forecasts is what puts the “market” in market monetarism. An interesting question is how much the Fed would have had to do to cause both actual and expected inflation (or nominal GDP) to change. My inclination is to believe that a lot more M would have merely resulted in a lot less V.


Chris Edwards dissects it.

Transfers are the largest and fastest-growing activity. Since 2000, transfers have grown at an annual average rate of 6.7 percent, which compares to purchases at 6.0 percent, compensation at 5.5 percent, and aid to the states at 5.0 percent. Total federal spending grew at 5.5 percent during this period, while the consumer price index grew at just 2.4 percent.

The CBO on the Budget Outloook

Director Elmendorf warns,

CBO estimates that federal debt held by the public will equal 74 percent of GDP at the end of this year and 79 percent in 2024 s. 4 (the end of the current 10-year projection period). Such large and growing federal debt could have serious negative consequences, including restraining economic growth in the long term, giving policymakers less flexibility to respond to unexpected challenges, and eventually increasing the risk of a fiscal crisis (in which investors would demand high interest rates to buy the government’s debt).

Some possibilities:

1. The CBO are Koch-funded austerians.

2. Just like the reduction in hours worked that the CBO forecasts for Obamacare, eventually increasing the risk of a fiscal crisis is actually a good thing.

3. More government debt gives the Fed more debt to buy, which in turn makes the stock market happy.