Two Types of Confidence

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Watch this video of Robert Shiller from a few years ago.

Source here. Pointer from Tyler Cowen.

Shiller’s body language, speaking style, and content suggest discomfort. He is like a kid (and of course he has very boyish looks for someone in his 60s) talking about why he never gets picked by the other kids to play in team games at recess.

And yet, when I showed the video to my students, one of them reacted by saying that Shiller seemed arrogant. And I think there is something to that, as well.

Contrast the confidence of Stanley Fischer, the voice of authority. Fischer knows that when he speaks, respectable macroeconomists stand with him. Over the years, he had make-or-break power over the careers of most of them.

Shiller has a different type of confidence. His is the confidence of the boy who sees the naked emperor. He has found what he is pretty sure are fundamental flaws with the mainstream world view.

So, there is establishment confidence. That is the confidence that you have the establishment with you, agreeing with your world view and respecting your power. Then there is outsider confidence, the confidence that you have in your ideas and a belief that it is better to be a low-status person with good ideas than a high-status person with mainstream ideas that are not as good.

It is easy for me to see Timothy Geithner not wanting to have Shiller in the room. Geithner has establishment confidence, which is threatened by outsider confidence.

Having said that, I myself am not heavily influenced by Shiller’s ideas. In finance, I like Frydman and Goldberg’s critique of rational-expectations modeling. In particular, different people are bound to have different information and different models. In macro, I am inclined toward a Schumpeterian story of difficult adjustment to changes in productivity in different sectors. However, if you want tell an aggregate-demand story, then I am with Shiller that “animal spirits” sounds like a better place to start than the Euler equation of a single representative consumer/worker.

Why Public Choice Matters

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Reihan Salam writes,

And so Gyourko calls for replacing the FHA with a subsidized savings program aimed at helping low-income borrowers accumulate a 10 percent down payment, a policy he describes as preferable for a number of reasons…

2. Focusing on borrowers helps ensure that benefits will flow to the intended beneficiaries rather than realtors and homebuilders.

From a public choice perspective, the realtors and the homebuilders are the intended beneficiaries. People with modest incomes are what Thomas Sowell calls the mascots for the policy. The housing lobby isn’t going to come out and say that they engaged in rent-seeking. They tell you that if you abolish FHA, you will be depriving people of the American Dream™.

Quality, Features, and Schedule

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From the book Lost Moon, retitled Apollo 13 after the movie was made:

Apollo was downright dangerous. Earlier in the development and testing of the craft, the nozzle of the ship’s giant engine…shattered like a teacup when engineers tried to fire it. During a splashdown test, the heat shield of the craft had split open, causing the command module to sink like a $35 million anvil to the bottom of a factory test pool. The environmental control system had already logged 200 individual failures the spacecraft as a whole had accumulated roughly 20,000.

In January 1967, one of the first Apollo spacecraft caught fire during an on-the-ground test, killing astronauts Gus Grissom, Ed White, and Roger Chaffee. At that point, NASA decided that quality was more important than schedule and they overhauled the Apollo project (although they still managed a moon landing 2-1/2 years later).

In some ways, the rollout of the Obamacare web site is reminiscent of this. The hurried schedule appears to have hurt quality. The rational thing to do now would be to let the schedule slip and resolve the quality issues.

Speaking of which, here is one recent report.

Recent changes have made the exchanges easier to use, but they still require clearing the computer’s cache several times, stopping a pop-up blocker, talking to people via Web chat who suggest waiting until the server is not busy, opening links in new windows and clicking on every available possibility on a page in the hopes of not receiving an error message. With those changes, it took one hour to navigate the HealthCare.gov enrollment process Wednesday.

Those steps shouldn’t be necessary, experts said.

Neither was the last sentence.

The Tea Party

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William Galston has some facts.

Many frustrated liberals, and not a few pundits, think that people who share these beliefs must be downscale and poorly educated. The New York Times survey found the opposite. Only 26% of tea-party supporters regard themselves as working class, versus 34% of the general population; 50% identify as middle class (versus 40% nationally); and 15% consider themselves upper-middle class (versus 10% nationally). Twenty-three percent are college graduates, and an additional 14% have postgraduate training, versus 15% and 10%, respectively, for the overall population. Conversely, only 29% of tea-party supporters have just a high-school education or less, versus 47% for all adults.

Although some tea-party supporters are libertarian, most are not. The Public Religion Research Institute found that fully 47% regard themselves as members of the Christian right, and 55% believe that America is a Christian nation today—not just in the past. On hot-button social issues such as abortion and same-sex marriage, tea partiers are aligned with social conservatives. Seventy-one percent of tea-party supporters regard themselves as conservatives.

Galston also has delivers some insinuations and assumptions. In particular, he assumes that the the Tea Party movement is some sort of dysfunctional emotional reaction and that the establishment is correct on the fundamental policy issues.

It is possible that this view is correct. However, the probability is not zero that the establishment view on the budget (spend more now; the future will take care of itself, or brilliant health care technocrats will take care of it, or something) is more dangerous than the view of the Tea Party. In fact, the establishment strikes me as suffering from a dysfunctional emotional reaction every time the topic of future budget commitments is brought up.

Conflict of Interest in Mortgage Lending and the Role of Regulation

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I received some pushback on this post. This is a response.

There is a narrative of the housing bubble/crash which tries to fit it into a neat oppressor-oppressed model. Greedy banks exploited naive borrowers in an era of libertarian deregulation. Emotionally, it as a satisfying story. Analytically, it is not. Here is why.

There are conflicts of interest between borrowers and mortgage originators, and there are conflicts between originators and investors. The financial crisis was created by the latter, not the former.

The main conflict of interest between borrowers and originators is that it is almost always in the interest of the mortgage originator to induce the borrower to pay an excessive fee and/or interest rate.

In my view, this conflict was not much of a factor in the housing crisis. The vast majority of the defaults were the result of the collapse of house prices, not the cost of mortgage loans.

Nonetheless, I have spent a lot of time thinking about this conflict and how to deal with it, because it bothers me that the most vulnerable people are the ones who are most likely to get ripped off. I do not think that market competition works very well to protect consumers, because a sophisticated lender can make it appear that he is offering the most competitive rate and then turn around and rip off the consumer. I do not think that letter-of-law regulation works very well, because you can never close all of the loopholes.

One possibility would be reputation systems. If an entity like Consumer Reports were to rate lenders and loan offerings, and enough consumers use that entity, then bad actors would be driven out of the lending market. Unfortunately, the most vulnerable consumers do not use these sorts of consumer rating services, so I do not think that solution will work.

The other possibility is principles-based regulation. Audit firms to ensure that their products, policies, procedures, and internal incentives are designed not to exploit vulnerable consumers.

The oppressor-oppressed narrative has lenders giving loans to borrowers when the lenders should know better but the naive borrower does not realize that he or she should not be getting the loan. Some comments on this.

1. Lenders are not omniscient. They make mistakes. A Type I error is making a loan that you think will be repaid, and it turns out to default. A Type II error is turning down a loan that would have been repaid. Until 2007, the main oppressor-oppressed narrative was that lenders were making Type II errors, particularly with respect to minorities. That is, the evil lenders were turning down too many good borrowers. When the crisis hit, the oppressor-oppressed narrative suddenly became the opposite. Lenders supposedly forced loans on unwitting borrowers who could not pay them, and we need to regulate lenders to make sure this never happens again. That is, originators deliberately committed Type I errors.

2. Under the old-fashioned originate-to-hold model, there is never an incentive for lenders to make loans that will not be repaid. You lose money on those loans. In this model, the bank pays its loan origination staff not on sheer volume, but on quality decisions, including rejecting loans as warranted.

3. On the other hand, with securitization, the originator’s idea of a good loan is any loan that can be sold to an investor, without regard to whether it can be repaid. When you deny a loan application, you cannot possibly make money on it. If you approve the loan and it cannot be repaid, that is someone else’s problem. This is primarily a conflict of interest between originators and investors, not between borrowers and lenders. At Freddie Mac, this conflict of interest occupied us constantly. Trying to keep originators from funneling bad loans to us drove enormous amounts of our staff time, business functions, policies, procedures, and contractual arrangements.

4. One of the illustrations of the conflict between originators and investors is that loan applications often include fraud and misrepresentation. The most common examples include over-stating the borrower’s income and/or lying about whether the borrower is going to occupy the home. Income misrepresentation is often initiated by the originator, trying to “help” the borrower get a loan. Occupancy fraud, on the other hand, is almost always initiated by the borrower. It can be hard for the originator to prevent this fraud, because it only becomes clear after the loan has been sold that the borrower never intended to occupy the home and instead is a speculator.

Taking all this together, I do not find the story of deregulation leading to the housing crisis to be very compelling. The main conflict of interest that caused the problem was the conflict between originators and investors. Basically, originators were able to foist bad loans on investors. This is not a case of the rich and sophisticated taking advantage of the poor and naive. On the contrary, the typical originator is a low-class guy working for a poorly-capitalized company in a highly competitive business. The typical investor is a sophisticated money manager.

Regulation was part of the problem, not part of the solution. The regulators’ perverse risk-based capital requirements encouraged the risk-laundering AAA-rated tranche business. And their attack on Type II errors prior to the crisis was at worst a major cause of the crisis and at best spectacularly poorly timed.

Blog Post of the Year?

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John Cochrane’s post on Nobel Laureate Robert Shiller is certainly a contender. It’s long, and you should read the whole thing. Of many possible excerpts, I choose:

No matter where you look, stock, bonds, foreign exchange, and real estate, high prices mean low subsequent returns, and low prices (relative to “fundamentals” like earnings, dividends, rents, etc) mean high subsequent returns.

These are the facts, which are not in debate. And they are a stunning reversal of how people thought the world worked in the 1970s. Constant discount rate models are flat out wrong…

To Fama, it is a business cycle related risk premium. He (with Ken French again) notices that low prices and high expected returns come in bad macroeconomic times and vice-versa. December 2008 was a recent time of low price/dividend ratios. Is it not plausible that the average investor, like our endowments, said, “sure, I know stocks are cheap, and the long-run return is a bit higher now than it was. But they are about to foreclose on the house, reposess the car, take away the dog, and I might lose my job. I can’t take any more risk right now.” Conversely, in the boom, when people “reach for yield”, is it not plausible that people say “yeah, stocks aren’t paying a lot more than bonds. But what else can I do with the money? My business is going well. I can take the risk now.”

To Shiller, no. The variation in risk premiums is too big, according to him, to be explained by variation in risk premiums across the business cycle. He sees irrational optimism and pessimism in investor’s heads. Shiller’s followers somehow think the government is more rational than investors and can and should stabilize these bubbles. Noblesse oblige.

By the way, Cochrane’s post on Lars Hansen is also top notch.

Pinpoint the Scandal

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The Sunlight Foundation reports,

All but one of of the 47 contractors who won contracts to carry out work on the Affordable Care Act worked for the government prior to its passage. Many–like the Rand Corporation and the MITRE Corporation–have done so for decades. And some, like Northrop Grumman and General Dynamics, are among the biggest wielders of influence in Washington. Some 17 ACA contract winners reported spending more than $128 million on lobbying in 2011 and 2012, while 29 had employees or political action committees or both that contributed $32 million to federal candidates and parties in the same period. Of that amount, President Barack Obama collected $3.9 million.

I don’t hold it against the contractors that they had prior government experience. I don’t hold it against them that they lobby or contribute to campaigns.

To me, the scandal is that there are 47 different organizations involved in building the site. I cannot imagine that any sane project executive would want it that way. I am just guessing, but it seems more likely to me that this many contractors were imposed on the project executive because there was a requirement to “spread the work out” to keep all these companies in the politicians’ pockets.

In any case, if you are trying to fix something that was assembled by 47 different organizations….good luck with that. Megan McArdle considers the possibility that it won’t get fixed in time.

Private Securitization and the Housing Bubble

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Adam J. Levitin and Susan M. Wachter write,

We argue that the bubble was, in fact, primarily a supply-side phenomenon, meaning that it was caused by excessive supply of housing finance. The supply glut was not due to monetary policy or government housing finance. The supply glut was not due to monetary policy or government affordable-housing policy, although the former did play a role in the development of the bubble. Instead, the supply glut was the result of a fundamental shift in the structure of the mortgage-finance market from regulated to unregulated securitization.

Pointer from Reihan Salam.

The implication is that if government regulates securitization, things will be fine. Some problems I have with this analysis:

1. They do not examine how the market for “unregulated” securitization was in fact bolstered by capital market regulations. Take away the regulatory advantage for AAA-rated and AA-rated securities, and I do not think that the securitization market is able to take off. Remember that capital requirements for banks were so perverse that holding a tranche in a pool backed by sub-prime mortgages required more less capital than originating and holding a low-risk mortgage.

2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.

3. The problem with private securities is not that they lack standardization. It is that the whole securitization model is flawed. It introduces more costs than benefits into the mortgage finance system. That fact has been obscured by all of the support that government has given to securitization, including the “too big to fail” status of Freddie and Fannie and the perverse capital requirements noted in (1) above.

Wither 90 percent of employment?

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Some analysts at the Gartner group are buying into Average is Over.

From 2020 to 2030, “you are going to see the first human-free enterprise — nobody is involved in it, it’s all software, communicating and negotiating with one another,” said Diane Morello, a Gartner analyst, who has looked at how smart machines will reshape employment.

The upshot?

On an extreme end of the scale, he [Gartner’s Kenneth Brandt] put the impact of smart machines at 90% unemployment, which is either catastrophic or leads to a utopia, where basic needs are met and people are free from drudge work.

Money Illusion in Wage Behavior: How Important?

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Simon Wren-Lewis writes,

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.

Read his whole post. The paragraph I quoted includes links that I did not transfer here. Pointer from Mark Thoma.

Some comments:

1. Just because something can be shown to exist at the micro level does not mean that it is important at the macro level. (This is in some ways equivalent to the point that just because you have what you think makes a neat microfoundation does not mean that it helps you with macro.)

2. In particular, if worker A at firm X suffers from money illusion, that does not imply that macroeconomic behavior will look like that worker and firm. There is plenty of exit and entry among firms as well as turnover in the labor force.

3. Indeed, I happen to agree with Robert Solow that what makes the DSGE framework so unpromising is that it typically insists on modeling a single consumer/worker/capitalist as representative of the entire economy. Obviously, you tend to forget about entry and exit and labor force turnover when you do that.

4. When one looks at macroeconomic data for evidence of money illusion, the results seem to me to be decidedly mixed.

a. Matt Rognlie writes,

A large output gap is extraordinarily effective at bringing inflation down from, say, 8% to 2%, but far less effective at bringing about a drop from 2% to -2%.

If that is true, then it looks like a point in favor of money illusion. To believe that it is true, you have to believe in the original Phillips Curve. That’s easy to do if your macroeconomic thinking was shaped by the 1960’s. Maybe it’s easy to do if your thinking was shaped by the last five years, although in that case you have only observed one region of the Phillips Curve. Looking at other time periods raises doubts.

b. If you put your chips on nominal wage stickiness to explain recessions, then I do not see how you avoid predicting a countercyclical share of labor income in GDP. That prediction is strongly violated by a number of downturns, including the current one.

c. Also, if you put your chips on nominal wage stickiness, youth unemployment should be relatively low in a recession. People who are just entering the job market are not comparing current job offers to previous salaries.

d. If there is money illusion, probably there are other illusions that allow employers to adjust at the margin without being able to reduce wages. As an employer, I can put more work on your desk. I can reduce bonus payouts. I can require a longer vesting period for stock options or pension benefits. I can reduce the match on your 401(K). I can increase what you have to contribute to health insurance. There seem to be enough margins available that sticky nominal wages should not matter.

5. On balance, I think that the case for wage stickiness as a crucial macroeconomic phenomenon is quite flimsy, notwithstanding the strong case for nominal wage stickiness that can be made by looking at micro behavior.