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Public animosity against Wall Street is high. Notably free market economists are taking the position that recent profits in finance are just about playing “heads I win, tails you lose.”
I am skeptical.
I am skeptical because this presumes that the financial industry is amassing profits simply by transferring money from some group of losers to itself. The immediate question is, why would the losers agree to this?
A possible retort is that the losers haven’t agreed to it. The losers may be the taxpayer who is by law forced to pay taxes. This is the bailout explanation.
However, as I have pointed out before, if this were true it would be really nice to see evidence of the taxpayer losing through bailouts. Right now the most direct evidence seems to be that the taxpayer has gained through bailouts.
Another retort might be that the loser is being consistently tricked. This is possible but we have to ask a few questions. One, why doesn’t the loser wake up to the fact that he or she is being tricked? Two, why doesn’t this pool of unrelenting suckers attract so many sharks that they drive each other’s profits down?
This is part of why I was skeptical about the notion of Consumer Financial Protection as doing anything major. Maybe consumers have no idea what they are doing and are constantly getting tricked. Yet, then why isn’t there a market for trust. Indeed, we have financial institutions like Credit Unions which would seem to offer more of the simple trustworthy products consumers advocates would like to see. However, people aren’t choosing them. Why?
Somehow people not only have to be fooled once, but they have to be willing to keep going back to the place that burned them. This implies some sort of fundamental decision making problem with the loser.
A potential answer to all of this is that there are deep biases shared by lots and lots of people. Overcoming that bias is a lot of work for some, but really easy for others. Thus those who easily overcome their biases reap are able to consistently get the better of those who can’t.
This post from Jeff Sommer seems to support that view. Sommer says
With bond yields rising and plenty of headlines about the fiscal pressures on embattled state and local governments, mom-and-pop investors have been selling tax-exempt mutual bond funds in droves lately. In the meantime, professionals have been making rich profits on bonds that have been swept up in the turmoil, including some from deep-pocketed institutions like Cornell and Harvard. There have been some good deals recently on California state bonds as well.
Though University Endowments usually don’t draw the same ire as private hedge funds they have been routinely successful in beating out the average investor. The news stories were about the big losses in the Great Recession, but the real story was the enormous returns made in the years leading up.
More importantly here is a potential source for the bias. Mom and pop investors have a hard time not responding to news stories. This need not be naiveté.
There could be a simple structural explanation. News stories about strained state budgets make it hard for Mom and Pop sleep at night with their retirement in munis. Not being able to sleep at night is a real cost. Mom and Pop sell their assets at a loss to improve their quality of life.
On the other hand, the Money Manager at Cornell is unaffected by news stories. He or she suffers no pain or discomfort from holding munis and so buys them at a gain.
The structural nature of this explanation explains why the market forces can’t make this problem go away. Mom and Pop aren’t consistent suckers. They are people responding to the real costs they face. This discomfort associated with fear of loosing your retirement is a real thing, it can’t simply be waived away.
Moreover, the number of people immune to this fear may also be limited, implying that the number of sharks is fundamentally limited.
In this case there is no natural mechanism that will stop Mom and Pop’s returns from going down and the professional managers returns from going up.
However, to the extent this is true the amassing of wealth in the hands of professional managers increases efficiency in the economy. It turns investment decisions over to people who can produce them at lower cost.
That is to say in this model of the world choosing investments is not simply a matter of information, it is a matter of being able to bear the emotional costs of making certain types of decisions. Sourcing those decisions to people with lower emotional costs really does increase efficiency.
Now to be clear I am not pushing this model as the truth. I am just kicking around ways to reconcile the fact that Wall Street is making outsized returns with what we know about markets and human behavior.
Jim Hamilton has another nice piece on Federal Reserve deposits. I have a couple of quibbles but mostly they are a matter of perspective. Hamilton says
I’ve been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody’s wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed
This is probably a workable framework for people who think of printing money and inflation as being synonymous. Though its not how I think about it. I think of issuing reserves as printing money.
Both reserves and cash are what we think of as “high powered money.” High powered money is the ultimate base for all the assets that we use for buying stuff, such as our checking accounts. The more high powered money out there the more checking accounts there can be.
Issuing a new checking account is how a bank makes a loan and this increase in lending increases demand in the economy. So, printing more reserves would tend to increase demand. That was pretty much how things worked up until the Fed started paying interest on excess reserves.
Once a bank issues a new checking account the law says that you have to dedicate some of your reserves to backing that account. These reserves are required reserves. Required reserves do not get interest payments from the Fed.
Thus when a bank decides to make a loan it has to switch some of its interest paying excess reserves over to non-interest paying required reserves. The fact that they loose the interest payment is what discourages them from doing this.
My overarching point is that there will be some people who suspect that Hamilton is shifting definitions to hide the Fed “true printing of money.” Yet, even if you think of issuing reserves as printing money – which is the frame that I use – Hamilton’ logic still follows through. It follows because the interest on reserves policy breaks the traditional link between printing reserves and increasing demand in the economy.
Hamilton goes on
Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it’s not clear that much if anything has to change as a result.
However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed’s plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.
So this is correct but one could easily confuse very wonky concerns with a breakdown in monetary policy.
So before all of this interest on reserves business the Fed managed the money supply by targeting the Fed Funds market. That is, the Fed kept the price at which banks loaned reserves constant.
Now suppose I am the manager at BigTime Bank. I decide for whatever reason that I want to make trillions of dollars in loans. To do this I need to acquire more reserves. I go into the Fed Funds market and start borrowing these reserves from other banks. This will tend to drive up the interest rate on reserves, which is the Fed Funds rate.
However, the Fed is targeting the Fed Funds rate. This means that in response to my action the Fed will increase the supply of reserves in order to push the interest rate right back down. The result is that the Fed automatically accommodated my desire to make a bunch of loans by increasing the supply of reserves.
So what stops me as the manager of BigTime Bank from flooding the market with new loans and driving up demand? What stops me is that I have to pay interest on all of these reserves. If the interest I am getting on loans is not competitive with the interest I have to pay to borrow all of these reserves then its not worth it for me to do this.
So, the ultimate control on how willing BigTime Bank is to make loans, is the Fed Funds rate. That’s why changes in the Fed Funds rate were historically a big deal.
Now, lets think about the current world. Here what is stopping BigTime Bank from making a bunch of loans? Its that by making a bunch of loans BigTime Bank has to move some of its reserves from excess to required and thereby lose the interest payment the Fed is offering on excess reserves.
From the BigTime Bank’s point of view this is the same cost. Issue more loans and either pay out more money from borrowing in the Fed Funds market or loose out on interest on reserves. In both cases it’s the interest rate that is holding the BigTime Bank back.
If the Fed wants to cool down the economy then, what it does under the current policy is to raise the interest rate on reserves. That will function just like raising the Fed Funds rate on the old policy.
So in terms of core monetary policy there is no real difference between regimes. There are a wonky concerns about making sure that the entire system functions without a hiccup since it hasn’t been done this way before.
There are also concerns about managing the Feds balance sheet. The Fed expanded the amount of excess reserves that banks had and then paid interest on those reserves. However, that wasn’t just a give away from the Fed to banks. In exchange the banks had to give the Fed some of their interest bearing assets including lots of Mortgage Backed Securities in the beginning and Treasury Bonds now.
The Mortgage Backed Securities and Treasury Bonds are both paying higher interest rates than the Fed is currently paying on reserves. So in terms of immediate cash flow the Fed is making more money now. However, Mortgage Backed Securities and Treasury Bonds are also “riskier” than reserves. They are risky because they pay a fixed interest rate, while the interest on reserves will theoretically fluctuate with the economy.
If economic growth picks up the Fed will be forced to raise the interest it pays on reserves. This is just like it would have to raise the Fed Funds rate in an overheating economy.
If the economy is growing fast enough then interest on reserves will have to be raised to a higher rate than the interest the Fed receives on Mortgage Backed Securities and Treasury Bonds. This would result in losses for the Fed. Its not exactly clear what “losses for the Fed” will mean, but for the sake of calm markets its best if we just don’t go there.
This means that the Fed will want to get out of the business of holding all of these securities at some point and its not clear how or when that might happen.
As the last person in the world to review Tyler Cowen’s The Great Stagnation everything I have to say will likely have been said already. You might say there is little low-hanging criticism fruit left. So I’ll keep it short.
I think Tyler is missing a lot in his solutions chapter, but that’s probably because his diagnosis directly implies so much about what we shouldn’t do policy-wise that simply convincing people that this part of argument is correct would already accomplish a lot in this vein. To the left he says that we cannot redistribute our way to growth, and to the right he says we can’t tax cut our way to it. Policy is what we do and what we don’t do, and if he could convince people that a) slow growth is a problem, and b) these policies aren’t solutions, then it would represent a huge and positive change-of-course. Going too far into policy recommendations beyond that runs the risk of distracting readers and critics from these key points.
That said, I don’t disagree much with his diagnosis, so despite understanding why he may have done so, I’m going to address some possible solutions I think he ignored. First and foremost is one of the key low-hanging fruits of yore: skilled immigration. If my count is correct, Tyler mentions immigration three times. Twice it comes in the form of what could be called his thesis statement:
“In a figurative sense, the American economy has enjoyed lots of low-hanging fruit since at least the seventeenth century, whether it be free land, lots of immigrant labor, or powerful new technologies. Yet during the last forty years, that low-hanging fruit started disappearing, and we started pretending it was still there.”
That free land is no longer available is obvious, and Tyler spends a lot of the rest of the book discussing technology, but what about the “lots of immigrant labor” that was so important before? Tyler discusses the possibility for improvement here in passing in the section on education:
“I’m also heartened by how many students from foreign countries wish to study in the United States, if only they could get the visa.”
Our current immigration policies could do a lot more to encourage skilled immigration, and worldwide immigration restrictions and inefficient immigration policies are preventing human capital from moving towards in best and highest use, which reduces global economic growth. Why was our past immigration one of the top low-hanging fruit available but the possibility for more and better immigration today barely worth mentioning? I’m not sure if Tyler does not go into this because he is not optimistic that this represents low-hanging fruit, or, as I mentioned above, because he does not want to alienate the reader with unpopular proposals for reform.
Another major issue ignored is, as Matt Yglesias has pointed out, intellectual property law. Is this an issue that has limited ability to improve economic growth? Or, like I suggested above, is Tyler ignoring divisive issues in order to focus readers on his central arguments. One piece of evidence against this hypothesis is Tyler’s inclusion, as one of the trends that should make us optimistic, the fact that democrats are turning against teachers unions, and how that makes more K-12 reform possible. Perhaps this seemed like a much less divisive point when Tyler wrote the book then it does today. In the end I am left unsure whether Tyler’s omissions reflect his pessimism, or if he’s just being strategic.
Paul Krugman is doubting that financial collapse was a key part of the recession
My take on the US economic crisis has increasingly been that banks were less central than many people think, while the housing bubble and household debt are the key players — which is why financial stabilization by itself wasn’t enough to produce a V-shaped recovery.
I am not sure how central people think the banks were so I am not sure how hard to push back.
My take is that household debt and the banking collapse were symbiotic in their destructive nature. At the center of the story, however, is money and credit.
Highly leveraged households meant that consumers were very sensitive to economic disruption. The danger in having a lot of leverage is that when things go bad they go really bad. The flipside of course is that when things go good they go really good. We have to have some story about how things started to go bad before household debt can be invoked to explain why things went really bad.
Debt is ultimately just a promise. Lots of debt is precarious when there are many interlocking promises that depend crucially on one another. If one person flakes – as eventually one person will – the whole network could crashing down.
When the banking sector collapsed it created a huge flake. Lending fell dramatically. Projects and production that were dependent on a smooth supply of lending could not go through. This rocked many households who were themselves in locked into sensitive promissory positions.
Now knowing that a flake was possible we might step back and ask either “why did we allow such sensitive networks to develop” or “why were housing prices allowed to climb on top of these tightly wound promises”
However, the more fundamental mistake was thinking that the Fed was prepared to firewall this whole thing if it went bad. It wasn’t that people couldn’t see the debt or the housing bubble building. Its that they thought it didn’t matter. The phrase commonly thrown around was “the Fed doesn’t target asset prices.”
That’s a more convoluted way of saying, this business with housing and mortgages may be a house of cards, but “so what?”
I don’t want to sound like I am pointing fingers here. I was deeply sympathetic to that view. Sufficiently powerful monetary policy I thought, and honestly still believe, could offset virtually any shock.
What we wasn’t appreciated fully enough was the fact that monetary policy would not be powerful enough; that central bankers are only human and that they will be hesitant to take extreme action.
In the light of those limitations it becomes more important to manage precarious situations as they arise. However, from the point of view of understanding the economy we also need to note, as Matt Yglesias reminds us to do, what powerful monetary policy can indeed accomplish.
I had been urging the Fed to effectively “go negative” by promising inflation. In Sweden, the central bank went literally negative.
For a world first, the announcement came with remarkably little fanfare.
But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.
Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.
The result was a surging Swedish economy. Indeed, as the FT reports, the fastest growth on record. This is coming out of a worldwide economic collapse.
This is also despite a long-run price to income profile that’s not that far off from the United States and peaked around the same time
I don’t think Krugman is doing this, but it is easy to get too caught up in thinking the macroeconomy is an extension personal finance. Having bought a house you couldn’t afford seems like a really bad situation to be in, and if everyone is in that situation then it seems like that ought to be really bad for the economy.
However, keep always in the front of your mind that a recession is not simply a series of unfortunate events. A recession is when the economy produces less. For example, the AIDS epidemic in Botswana is a horrible event for millions of people that uprooted lives and destroyed families and promises to leave a generation of orphans.
However, Botswana’s GDP growth didn’t turn negative until Lehman Brothers went under.
That a Global Financial Crisis could do what rampant death and disease could not, is an important indicator of the nature of recession.
A recession isn’t when bad things happen, whether that’s loosing your house to foreclosure or your parents to AIDS. A recession is when the economy produces less.
Somehow you have to make a link between the bad thing happening and the economy producing less. I maintain that, that link almost always runs through the supply of money and credit.
The debate over public sector unions has been lacking in economic arguments, and the justifications argued on unions behalf have not been of the kind one usually finds in these debates among labor economists. The two main economic arguments for unions are to provide workers with voice, and to counteract monoposonies. My main concern here is the latter, but I’ll briefly address both with regard to teachers unions in particular.
With respect to the voice function of unions, a standard reply of labor economists is that the National Labor Reform Act should be changed to allow more non-union types of voice. For instance, the act prevents firms from supporting any type of labor organization. That means a firm is unable to organize a non-union way for workers to voice complaints, settle disputes, negotiate over working conditions. As Barry Hirsch argues, these parts of the NLRA, while not without legitimate purposes, ”restrict development of nonunion vehicles for employer-employee, cooperation and productivity-enhancing voice.” Canada, in contrast, does not bar employer-initiated or supported labor groups. And every progressive loves Canada, right?
The second economic argument for unions is to help counteract the power of monopsonies. In the public sector, this is certainly a plausible complaint. Given that governments are often the only ones providing some services, they may have large degrees of labor market power, also called oligopsony power. While few may be explicitly making this economic argument, the common concerns about teacher powerlessness in the face of fickle administrators certainly reflects this problem. In a well-functioning and competitive market, administrators would face repercussions for firing good teachers. For one thing, parents would be upset, and competitive enterprises suffer consequences when customers are unhappy. In addition, competitive labor markets would mean teachers would demand a risk premium to work at firms where they could be fired for political or illegitmate reasons. When there is no competitive check on a school, neither of these repercussions is as important.
Thus if we are concerned about the oligopsony power of schools, and we want teachers to be treated as other comparable professionals are treated, then one possible solution is to make schools more competitive by allowing more school choice, either through charters, vouchers, or simple choice among public schools. This way, if an administrator has a reputation for firing good teachers, there are consequences. This will not prevent unjust firings from happening ever, as no system could, but it will make it less likely. After all, we don’t worry too much that about good accountants getting fired, do we?
On the other hand, the lack of competition for government, and schools in particular, also provides the opportunity to earn so-called economic rents just as lack of competition does in the private sector. These rents may be shared in an organization among administrators and teachers, meaning that less competition means higher pay for teachers. So while more competition can mean more labor market power relative to administration, it may also theoretically mean lower pay.
In order to shed some empirical light on this issue, a recent paper (I can’t find an ungated version) by Lori Taylor at Texas A&M looked at teacher pay in Texas. Importantly, Texas is a right-to-work state so collective bargaining does not confound her analysis. What she found was that in a handful of very uncompetitive markets, teacher salaries actually would decrease as a result of more competition, meaning that they were sharing in some of the economic rents. In most markets however, oligopsony power meant that increasing competition among schools would actually increase teacher salaries. Here is how Taylor summarizes her results:
More than 88% of the teachers with less than 20 yr of experience would benefit from increased competition. Seventy-nine percent of the highly experienced teachers would also benefit. Only 2% of beginning teachers, 5% of experienced teachers, and 6% of highly experienced teachers could expect increased competition to lower their pay.Profits and Rent-Sharing.
To provide one example, she highlights the Houston, Dallas, and San Antonio areas, home to more than 70% of the charter schools in Texas. Prior to the existence of these charter schools, a 1% increase in competition would increase teacher salaries by 2.5%. Given these increases in salaries, it seems likely that non-wage power of teachers is increased as well, meaning it’s harder to fire a good teacher for bad reasons.
Despite the theoretical ambiguities discussed above, these really are common sense results: the more labor market opportunities you have, the less power your bosses have over you, and the more competition there will be to hire the best teachers. The only place this isn’t going to be the case is areas where teachers are earning rents and schools are very uncompetitive. In these areas teachers are already likely to be overpaid, and the other benefits from competition, like better student outcomes, are likely to be the greatest. Long story short: more competition helps the teachers who need it.
The risk of inequality is that government reform, and for that matter any policy change that makes anyone not rich less than better off, will be opposed on crude populist grounds. The pro labor left has be extremely successful in painting the attempt to get rid of collective bargaining as a class issue. In fact, they haven’t really had to paint much, as it were, since people seemed ready and eager to interpret it as such without much prompting. Sure, it helps that Governor Walker has been somewhat ham handed, and the involvement of certain billionaires has certainly helped reinforce the image of rich versus poor. It also doesn’t help that the policy is being sold at the same time as widespread austerity cuts that do seem to be to an unfortunate degree targeted at the poor.
Nevertheless, the constant appeals to the dwindling middle class, income inequality, and the top 0.1%, in a debate about a policy that will neither rescue nor sink the middle class provides us with a glimpse of how inequality can poison seemingly unrelated issues. In the long-run the removal of collective bargaining will almost assuredly benefit working class people, who depend much more on public goods and services, than hurt them. It is the worst off, after all, who are most in need of better functioning schools. And as we’ve seen, when conservatives are pushed up against more taxes or less services, they’re choosing less services.
Some good policies require sacrifice, and sometimes working and middle class people will be made worse off, especially in the short-run. While this may seem unfair it is necessary if we are to progress, and all of us -even those suffering from today’s economic shocks, even the poorest among us- owe our wealth to our past generations willingness to bear these short-run costs of living in a dynamic economy. I’m worried that future generations will suffer because class resentment and inequality will cause us to adopt and preserve bad policies just because they manage to in some myopic way to stunt the costs of this dynamism.
I don’t really have any suggestions about what to do about this. It’s not clear more education can fix inequality, but it is certainly the least damaging way to try. My preferred approach then is that we should try really hard to provide children with a world class education system, and if the funds are going to be used productively, then we should be willing to pay higher taxes to do it if that’s what it takes. If it works, then in the long-run we’ll need less prisons, less inefficient policies like collective bargaining, and less pure transfers. If it doesn’t, then hopefully we’ll at least convince people that we’re trying, and hopefully that will make the preservation of our dynamic economy more likely.
Ezra Klein pinch hits for the med skeptics
File this one under "health care doesn’t work nearly as well as we’d like to believe." A group of researchers followed almost 15,000 initially healthy Canadians for more than 10 years to see whether universal access to health care meant that the rich and the poor were equally likely to stay healthy. The answer? Not even close.
. . .
The problem, the researchers say, is that the medical system just isn’t that good at keeping people from dying. "Health care services use by itself had little explanatory effect on the income-mortality association (4.3 percent) and no explanatory effect on the education-mortality association," they conclude.
Ezra seemed to backtrack a little in a later post but I can see he really wants to come over to the skeptical side. Don’t let Tim Carney’s abrasiveness scare you away. The skeptics really are a nice, internally consistent bunch.
I, for example, have never paid a dime of my own money for my own health insurance. I have always chosen the lowest quality health plan when rolled into my employment package and no health plan when not.
Really quickly I’d also just like to plant another seed. There are clear cases when medical care saves people’s lives. However, if access to more medical services isn’t associated with a longer life, then we have to take seriously the proposition that medical care is also causing a significant number of deaths. I’ll get into the life expectancy of Christian Scientists in another post.
All that having been said, what I really wanted to talk about the possibility of education improving health outcomes.
Ezra goes on
Rather, the best way to make people healthier would be to get health-care costs under control so there’s more money in the budget for things like early-childhood education and efforts to strip lead out of walls, both of which seem to have very large impacts on health even though we don’t think of them as health-care expenditures.
Arnold Kling cosigns on the general concept education for health
My guess is that if you want to improve health outcomes in the United States, ignore health insurance and focus on literacy. Even if it has nothing to do with whether or not they can follow a doctor’s written instructions, my guess is that better literacy has a positive impact on health outcomes.
I am skeptical about a fundamental link here. I suspect we have two things going on.
First, education confers status and status is related to health outcomes. For example Oscar winners live longer than those simply nominated. How this link occurs is not totally clear. It seems that the hormones associated with stress and disappointment – cortisol for example – reduce long run health. However, this may not be the mechanism. No one really knows at this point.
Second, for a long list of reasons there is correlation between education and physical attractiveness. Physical attractiveness is by evolutionary design a proxy for health. Which to say, healthier folks are more likely to become well educated.
This makes me doubt that power of health improvements from increasing education.
In general it is just damn hard to improve health outcomes. Our bodies are the product of about 4 billion years of evolution. Just making sense of how they work is hard enough. Making them work better is a herculean task.
Arnold Kling asks why economists think they can improve educational outcomes by firing the worst teachers (a position he labels E) but none of us think that we could improve financial performance by firing the worst financial managers (a proposition he labels F).
He concludes
Both (E) and (F) are false, but economists have much softer priors about (E). That is, economists are strongly inclined to believe that outstanding performance in money management is luck. As a result, when someone claims to find something like (F), you can be sure that a significant effort will be expended on research designed to disprove that finding. On the other hand, economists would, if anything, like to believe (E), so that when someone claims to find something like (E), relatively little effort is expended trying to disprove that finding.
On a basic level the difference , somewhat reflected in Arnolds third option, is that economists believe that we know up front who the best or worst teachers are going to be over the next five years. Its the teachers who were the best or worst over the last five years. That is, economists believe individual teacher quality explains a huge fraction of the variation in student outcomes.
However, economists don’t believe that we can pick the best or worst financial managers over the next five years, just by looking at the best or worst from the preceding five years. That is, economists tend to think luck is the primary determinant of financial returns.
Now, admittedly Warren Buffet is an embarrassing counterexample for the luck hypothesis. On the other hand Merton and Scholes really looked like the smartest guys in the room until Long Term Capital blew-up in everyone’s faces. Moreover, Buffet’s legendary status makes him the exception that confirms the rule.
More deeply, economists argue that the most sensible way to invest is to simply buy a weighted average of all investment vehicles based on your risk tolerance.
Yet, few of us believe that the most sensible education is simply to take a weighted average of all currently used curricula and methods.
