Margin Requirements and Entrance Fees

Tyler Cowen writes,

Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

Think of what AIG was doing when it was writing credit default swaps on mortgage securities. It was taking tail risk by writing out-of-the-money options. If you believe Gary Gorton, they were fine, except that in 2008 their counterparties demanded collateral that they did not have, not because the options were in the money but because the options were closer to being in the money.

Today, if you want to pick up the nickels that you can earn by taking tail risk, you need to put up more margin. What Tyler is suggesting is that this increases the demand for safe assets relative to what it was prior to 2008. So even if the real return on T-bills is negative, they are worth it for financial institutions who use them to meet margin requirements on trades that enable them to make a profit.

If the financial institution is helping the economy by taking the tail risk, then it’s all fine. But Tyler suggests that the financial institution is not helping the economy (AIG was an enabler of the housing bubble). In that case, we would be better off with less tail-risk taking, which in turn would reduce the demand for safe assets and lead to a better allocation of saving and investment.

Stricter bank regulation may or may not help. The effect of risk-based capital regulations was to increase the demand for AAA-rated securities, which in turn increased the demand for credit default swaps written by AIG. So that was a case in which stricter bank regulation actually created (apparent) profit opportunities in taking tail risk. If regulation still has that effect, then it will increase the fundamental distortion in financial markets.

Vaclav Smil

Interviewed here. He comes across as the opposite of George Gilder, in that he is very much a materialist.

we consume so many more products that there’s been no absolute dematerialization of anything. We still consume more steel, more aluminum, more glass, and so on. As long as we’re on this endless material cycle, this merry-go-round, well, technical innovation cannot keep pace.

Pointer from Tyler Cowen.

I once got to hike with Smil during a break in a conference put together by John Baden. That was a treat.

Skeptics on Pre-School

Grover J. “Russ” Whitehurst writes,

Unfortunately, supporters of Preschool for All, including some academics who are way out in front of what the evidence says and know it, have turned a blind eye to the mixed and conflicting nature of research findings on the impact of pre-k for four-year-olds. Instead, they highlight positive long term outcomes of two boutique programs from 40-50 years ago that served a couple of hundred children.

Pointer from Tyler Cowen. I take the first sentence to be a swipe at James Heckman.

Whitehurst summarizes the results of a larger, more recent study, and concludes

This is the first large scale randomized trial of a present-day state pre-k program. Its methodology soundly trumps the quasi-experimental approaches that have heretofore been the only source of data on which to infer the impact of these programs. And its results align almost perfectly with those of the Head Start Impact Study, the only other large randomized trial that examines the longitudinal effects of having attended a public pre-k program. Based on what we have learned from these studies, the most defensible conclusion is that these statewide programs are not working to meaningfully increase the academic achievement or social/emotional skills and dispositions of children from low-income families.

I received a review copy of The Smart Society, by Peter D. Salinas, a former provost for the State University of New York. Unlike me, he takes a fairly optimistic view that school reform can have a big effect on outcomes. Continue reading

What I’m Reading

The Rebirth of Education: Schooling Ain’t Learning, by Lant Pritchett. In short, it is an informed polemic against top-down, state-run school systems in underdeveloped countries, notably India. Tyler Cowen mentioned it, but otherwise it has received no play anywhere. Maybe it is just too contrary to conventional wisdom for people to grasp.

It is possibly the best book I have read this year. It immediately vaults onto the list of libertarian classics. This is in addition to being an important book about education in underdeveloped countries.

I will have to finish it and then re-read it before writing a more comprehensive review.

Secular Stagnation? Seriously?

Paul Krugman endorses the idea. Pointer from Mark Thoma.

My own first reaction to Larry Summers’ talk was to write

there are so many problems with Summers’ story that one does not even know where to begin.

Tyler Cowen writes,

I don’t mean this in a rude or polemic way, but the arguments we have been reading do not yet make sense.

Cowen’s stagnation story is that the pace of innovation has slowed, resulting in declining growth in aggregate supply. In contrast, Summers’ story is one of a permanent shortfall of aggregate demand, due to an excess of desired saving over desired investment, which can only be eliminated at a negative real interest rate.

Here are some criticisms that come to mind.

1. If “the” full-employment real interest rate is negative, then why do we need quantitative easing? Why does not the excess of saving over investment not by itself drive long-term rates to zero?

2. Summers wants to claim that full employment has been achieved in recent years because of asset bubbles. However, in a world of negative real interest rates, there is no such thing as an asset bubble. Real assets have infinite value in such a world.

3. As Tyler points out, it is hard to reconcile positive economic growth with negative real interest rates. We have had positive economic growth, even since 2008.

4. As Tyler also points out, we observe higher interest rates for risky assets. In fact, if you want to understand the low interest rates that Summers and Krugman are talking about, then my suggestion is to “follow the guarantees.” In one way or another, the U.S. government has provided a guarantee on many investments. Government bonds are one example. Mortgages are another.

5. The prime rate at banks averaged 5 percent from 2001-2004, almost 7 percent from 2005-2008, and 3.25 percent from 2009-2012. Inflation over these periods averaged 2.3 percent, 3.4 percent, and 1.5 percent respectively, so that the real rate of interest has been positive throughout.

6. Summers’ revival of the secular stagnation hypothesis has not been broadly peer reviewed. Before people jump on the bandwagon, I would wait until it has been evaluated by a broader range of economists.

Bimodal Salaries, Unimodal tuition?

Peter Turchin writes,

the left peak has hardly advanced and is currently (as of 2011) located at $50K. Given that the debt burden of an average law school graduate is twice that (over $100K), it means that for all practical purposes the individuals in the ‘loser’ category will never be able to repay their loans. In other words, the group of elite aspirants who have gone to the law school since 2001 have been sorted into two completely separate categories: those who succeeded in entering the top ranks of the elites and those who have failed utterly, with very few people in between.

Read the whole thing. Pointer from Tyler Cowen.

It appears that there are two markets, one for elite lawyers and one for ordinary lawyers. However, law school tuition is relatively homogeneous. At some point, I would expect to law school tuition fall sharply at all but the elite institutions.

Wealth Illusions

From Frederick Taylor’s The Downfall of Money:

In the end, no one really got their money, not even the Americans. Germany used the American loans it received under the 1924 Dawes plan to pay reparations to the French and the British, who in turn used the money to service their own debts to the USA. Then, during the Great Depression, all the major powers, including Germany, France and Britain, effectively defaulted on what they owed to America, and into the bargain the Germans defaulted on reparations.

This reminded me of one of Tyler Cowen’s mantras, that we are not as wealthy as we thought we were. His implied model of recent economic events is that we had illusory wealth during the housing bubble and then reality bites. Some random thoughts:

1. Taylor’s picture of the 1920s suggests a possible wealth-illusion story for the Great Depression. The Germans did not think that they were going to pay anywhere near the full amount of reparations, so they did not count that full amount in their liabilities. However, the Allies were counting on receiving the full amount of reparations (as my previous post on the book indicates, the citizens were led to expect even more than the political leaders were really going to try to collect). In effect, reparations were being double-counted as aggregate wealth, with consumers in the Allied countries counting them as assets but without offsetting liabilities in German households. Then, around 1930, Allied households finally marked down their wealth, and you had the Great Depression.

2. Macroeconomists know that Keynesian fiscal policy effectiveness depends on wealth illusion. The question “Are government bonds net wealth?” must be answered “yes” in order for deficit spending to raise aggregate demand. Otherwise, if Barro-Ricardian equivalence holds (so that the increased wealth of the holders of government bonds is offset by the decreased wealth of households who have marked up their future tax liabilities), then deficits are not clearly expansionary.

3. In theory, wealth illusions do not have to be destabilizing. Economic activity does not have to rise and fall just because people have higher or lower perceptions of wealth. Complete wage and price flexibility would be sufficient to maintain full employment. I am not sure that complete wage and price flexibility is even necessary. However, in practice it seems likely that wealth illusions would prove to be destabilizing.

4. From a PSST perspective, one can imagine all sorts of patterns of trade that depend on perceptions of wealth. When wealth illusions break down, it is not as if all households take an equally proportionate hit. Some households lose more than others. For example, when the housing bubble broke, people who had a lot of their (illusory) wealth in housing lost more than people who did not. So when (illusory) wealth is redistributed, old patterns of specialization and trade become unsustainable, and there will be unemployment until new patterns are established.

5. One could argue that the increase in government debt financed by quantitative easing is fostering a wealth illusion in countries where it is taking place. Indeed, that is in some sense the intent–see point (2). Perhaps we should be more worried than we are about how the process of unwinding this wealth illusion can be accomplished without pain. Actually, I am plenty worried about it.

Social Heterogeneity

Kevin Drum writes,

Via Harrison Jacobs, here’s a recent study showing the trend in income segregation in American neighborhoods. Forty years ago, 65 percent of us lived in middle-income neighborhoods. Today, that number is only 42 percent. The rest of us live either in rich neighborhoods or in poor neighborhoods.

Pointer from Tyler Cowen.

Drum goes on to say,

We increasingly lack a shared culture or shared experiences, and that makes democracy a tough act to pull off. The well-off have less and less interaction with the poor outside of the market economy, and less and less empathy for how they live their lives.

Some comments:

1. The increase in segregation by income over the past forty years is something that one can see and feel, at least if you are as old as I am.

2. My guess is that you could observe similar trends in terms of education. I would bet that today more Harvard students come from the top 20 percent of the income distribution than was the case 40 years ago. I would bet that more students who do not attend college come from the bottom 20 percent of the income distribution. Note that by “more” I do not mean “every.” With “gifted and talented” programs, “magnet schools,” and whatnot, school classrooms are much more segregated by income class than they were forty years ago.

3. Many trends are at work that are reducing social homogeneity. Skills are diverging, tastes are diverging, and cultural habits are diverging.

4. Both liberals and conservatives lament heterogeneity and would like to undertake a project to restore America to some prior era of less diversity. For liberals, economic homogeneity takes precedence. For conservatives, cultural homogeneity takes precedence.

5. Music might be a useful metaphor. In 1970, a lot of people listened to two or three popular radio stations in every city. Probably 3/4 of Americans recognized most of the top ten songs of that year. Even today, my high school students probably would recognize some of those songs. But music is much more fragmented now. Songs are iconic only for particular sub-cultures and only for short periods of time.

6. It could be that the project of returning to some bygone age of cultural and/or economic homogeneity is as unrealistic as expecting everyone to enjoy Simon Garfunkel, the Carpenters, and The Guess Who.

7. The middle of the twentieth century was about masses. Mass consumption. Mass production. Mass warfare. Mass destruction. Mass politics. We are not in the middle of the twentieth century any more.

When Will the ACA Exchanges Be Working?

Tyler Cowen writes,

The exchanges will be mostly working by March 2014, but by then the risk pool will be dysfunctional. In the meantime, real net prices will creep up, if only through implicit rationing and restrictions on provider networks. The Obama administration will attempt to address this problem — unsuccessfully — through additional regulation.

I disagree with the March 2014 date. My opinion of the distribution of likely outcomes is that it is bimodal. There is a high probability that the exchanges will be working at the end of November. I think that there is an even higher probability that they will be working never.

Why the end of November is plausible:

1. We may be hearing overly dire descriptions of the state of the system. Anyone from the outside who looks at a system will think it cannot possibly work. I once worked with a CIO who said that one of his iron laws was that anyone new on a systems project would say, “The person who originally designed this system was an idiot.”

2. Jeff Zients, the new manager, put a stake in the ground for late November. If he thinks that it is unlikely, he is, if nothing else, taking big personal risk to his own reputation.

3. CMS, the agency that was in charge, is actually a pretty effective group. They also pulled off something similar in implementing the Medicare prescription drug plan. It is plausible that they anticipated the major problems, and only minor fixes are now needed.

Why “never” is even more plausible:

1. The fundamental challenges may be very great. In the worst case, suppose that some of the legacy systems that the ACA web site has to access were built around 1975. Back then, in order to pull data out of such a system, you wrote a SAS program, put it into the queue of an IBM-370, waited for an operator to mount a data tape, and if all went well (no JCL errors, no logic errors in your SAS code), after a couple of hours you had a nice fat printout. Now, we want to be able to query those systems in real time, with perhaps hundreds of queries arriving at once…..Hmmm, maybe not even hotshot web programmers wielding the latest methodological buzzwords can pull that off so easily

2. While the Suits talk about bugs or glitches, it looks to geeks as though the problem is design flaws. Those are very hard to fix, particularly in a system that is so large already. Everything about the existing design is there for a reason. It may not be a good reason, but if you “fix it” without understanding the reason, you could be in for a nasty surprise. I just don’t see how you fix design flaws in four weeks.

3. Everyone says that there was not sufficient time to test the system before putting it into operation. Between now and the end of November, it does not seem as though there is sufficient time to test any major changes to the system. If you redesign parts of the system, then you have to write a test plan that is appropriate for the new design. Four weeks may not even be enough time to write a good test plan, much less carry it out.

4. If it is still broken at the end of November, the chances increase that starting over is the fastest path to a working system. But starting over requires a stronger political consensus in favor of the policy that the system is supposed to implement. And we do not have that.

Megan McArdle has more comments, focusing on the disconnect between thinkers and doers in the Obama Administration.

A DY2PVSC Post I Wish I Had Written

From someone who prefers to blog anonymously.

Economics is a science, but it is a very politicized science. The Medicaid study, with its ambiguous results, offered justification for the policy proposals of both supporters and opponents of ACA, for example. Both sides were offering an incomplete picture of the study in this debate, but both sides were also correct the claims they made even if they strategically left out inconvenient findings.

Pointer from Tyler Cowen.

Read the whole thing. He is reacting to a column by Raj Chetty, and I had a similar reaction. While proclaiming the scientific virtues of economics, Chetty was sneaking in his own biases, through a selective presentation of results.

The more important point is that we all are tempted to do this, and we need to work hard to resist such temptation. One of the reasons for my occasional DY2PVSC posts (“Did you two people visit the same country”) is to try to pair up research that supports one side with research that supports the other.