You are currently browsing the monthly archive for December 2011.

Kate Mackenize, pounds the table over the balance of payments

Just in case the point has not been hammered home over the last few years, or even the last few days, here’s a chart showing how quickly and dramatically the external debt imbalances got out of hand in the eurozone:

Euro imbalances - 2002 - 2010 -  Net international investment position - Mark Carney, Bank of Canada

It’s from a speech given in Toronto earlier this week by Canada’s central bank governor Mark Carney, who recently took over from Mario Draghi’s former gig as chair of the Financial Stability Board, titled “Growth in the Age of Deleveraging”. Carney points out that it doesn’t matter whether the debt is initially public or private, because private debts inevitably become public.

And of course, Europe is a microcosm (or, whatever a big microcosm is called) for the whole world. As Carney says, “Accumulating the mountain of debt now weighing on advanced economies has been the work of a generation.

This in itself, however, is not enough.

Lets imagine that Portugal received massive inflows of foreign capital from 2002 to 2010. Then it used that capital to stockpile massive quantities of gold.

Where would they be today?

Chances are living the high life.

If for some reason creditors wanted their money back Portugal could either ask them to take payment in gold or slowing sell off their holdings to meet credit redemptions.

The point isn’t that there is something magical about gold. Its that there is something magical about the ability to send back whatever you borrowed.

One of the things about Europe’s situation and that in America as well is that what was borrowed was structures. Or, to follow the chain out a bit more the balance of payments supported at much higher investment rate in structures without a corresponding drop in concurrent consumption.

Yet, Portugal can’t just ship Villas back to Germany or China to make good on its debts.

What it could do is ship Germans or Chinese to Portugal to stay in the Villas. That would require, however, increased expenditures on vacations in Germany or a falling Euro to make it more affordable for the rising Chinese middle class to visit Portugal.

Jared Bernstein is headed in the right direction

I’m sure that if you could look at the electrical impulses in the typical person’s brain and say “debt” or “deficit” the synapses that fired would be ones associated with negativity. Yet debt has obviously been an economic mainstay since before money existed—members of bartering economies constantly owed one another goods and services. Without debt, very few people would own homes or go to college. But it has a bad reputation right now chiefly because there’s so damn much of it.

Indeed, these two things likely go hand-in-hand. The reason you feel bad about being in debt is because your brain evolved in a pre-monetary society where debt as social obligation was the glue that held the community together.

In a modern monetary economy this is no longer true. Bankruptcy courts and credit agencies have replaced shunning as the means of enforcing promises. Not meeting ones debts no longer implies social death. Indeed, typically the worst that will happen is that you won’t be allowed to borrow again.

Though, as we will see over the next few years that won’t happen either. Creditors have to loan to someone. Broken promises will be forgotten and forgiven because else there is nowhere for the money to go.

Yet, none of this will stop folks from feeling like the creditor has something over the borrower, when in reality the opposite is true.

It will, however, mean outsized profits for the small minorities of human beings born without that particular wiring. We often call them investment bankers.

Based on underlying fundamentals I would expect household debt service to hit multi-decade lows by mid-2012

FRED Graph

At this point unless there is a major uptick home equity borrowing – unlikely – or a major increase in interest rates it is pretty much baked into the cake.

From Catherine Rampell

Household formation has slowed dramatically since the recession, as cash-strapped families double up and unemployed recent college graduates are unable to leave behind their parents’ couches. To judge just from demographic statistics, more than a million households that should have been formed in the last few years weren’t, according to Mark Zandi of Moody’s Analytics.

The tally of missing households is approximately equal to the country’s current surplus of vacant homes. The implication is that once people start getting jobs again, doubled-up families will peel off and quickly sop up a lot of that excess housing inventory.

If by chance you don’t frequent the geekier side of the twitterverse you might have missed the outpouring of wit-in-140 that followed this post by Gene Marks

If I was a poor black kid I would first and most importantly work to make sure I got the best grades possible. I would make it my #1 priority to be able to read sufficiently.   I wouldn’t care if I was a student at the worst public middle school in the worst inner city.  Even the worst have their best.  And the very best students, even at the worst schools, have more opportunities.  Getting good grades is the key to having more options.  With good grades you can choose different, better paths.  If you do poorly in school, particularly in a lousy school, you’re severely limiting the limited opportunities you have.

As it so happens I was a poor black and I built a rational expectations model of the very phenomenon Marks describes.

I look back on it and I see how it was the origin of the Smithian worldview I push today.

The problem is this: You want to build a model of the choices facing a poor black kid in a bad environment. You need to sketch out a decision tree and then turn that into a choice function and then – in my case – simulate the interaction between neighborhoods and student choice on a computer.

Significant insight can be gleaned from the closed form solutions but to really watch the magic you need numerical estimation.

In building this model one thing became glaring clear. The life choice that Mark’s outlines and that is advocated as prudent and reasonable by society is in fact incredibly risky.

I probably can’t convey the view-quakiness of this revelation because its now so entwined with the way I see the world. However, imagine the choice of a poor teenage girl deciding whether or not to have unprotected sex and possibly become pregnant, or to study hard, make good grades and stay in school.

Forget the unprotected sex itself, which we almost all find enticing.

The key is the pregnancy. For a 16 year-old girl regular unprotected sex will result in a full term pregnancy in the modern world with roughly probability one. There is little chance she will die in child birth. Late term miscarriages at her age are rare.

Now, just like any other parent the birth of that child will be the most important event in her life. And, the love of that child will be the most valuable thing she experiences. Some people say that looking back their career was more important than their children, but those people are few and far between.

So, if the girl has unprotected sex she gets right here, right now, the most important and valuable thing in life will happen immediately with PROBABILTY ONE.

Its difficult to get better than that. Waiting at all creates a risk that something will happen to prevent this. Even, if you can be sure it won’t – and many couples find out unfortunately that you can’t be so sure – you still have to discount the time. You have wait for the most valuable thing in your life.

Mark’s would have her set all that aside. Put away time that she will never get back – you must remember that no matter what you will never get these days back – for the chance that supposedly she will go on to college and get some job and meet some guy and then later have a different child under what might be better circumstances.

This is a risk. Taking Marks advice means that you lose a sure shot at the greatest thing in life. It means that you potentially waste time and time is the currency of life. He wants to convince you that the gamble might pay off.

Yet, how is a Bayesian supposed to tackle this problem?

I look around in my neighborhood and by definition none of the folks here have done what Marks suggests. These people are like me. I have no reason to believe that I am different.

What kind of sense would it make for me to take this gamble when no else does? No, it makes more sense to play it safe and take the sure thing.

Now, of course teachers, parents and helpful people like Marks will tell me to do otherwise. Should I believe them?

Not on your life.

By their own admission they want to see me “succeed.” That is, they benefit from my gamble. Yet, they incur none of the risks. They don’t lose time with their child. They don’t risk their fertility. They don’t experience the disutility of social climbing.

Heads they win. Tails I lose.

Listening to them would be nothing short of foolish.

And, so of course the teenage girl does not listen. Not because she is irrational, but because she is rational.

Indeed, strategies to get her to change her mind hinge on coercion or leveraging irrationality. Parents may threaten as poor parents do not have the resources to bribe.

Some teachers will try to convince students that they can do anything if they try. Clearly they can not. Others will significantly downplay the disutility of social climbing. They will cast crossing into the cultural unknown as uplifting, not depressing and possibly deeply lonely. These kind of stories border on outright deception.

Everyone will try to get her to “believe in herself.” This is an attempt to induce Caplan-esque rational irrationality. That is, to attach an emotional preference to a belief about the natural world. This is epistemologically equivalent to the nationalistic fervor that accompanies “America First.”

And, if that doesn’t work some teachers will resort to honest guilt: “We took a chance on you, now you take a chance on yourself.”

However, all of these strategies come down not to encouraging prudence and rationality, because the prudent and rational thing to do is to get pregnant. They instead hinge on emotional appeals to irrationality, noble lies and social, and sometimes physical coercion.

If you were a poor black kid, that’s what you would face.

A post up at Barry Ritholtz’s place says the following

As we suspected in our last update in September, the flight to quality funding of the U.S. budget deficit would replace the end of QE2 and almost 100 percent indirect financing of the deficit by the Federal Reserve.  Looking at the chart one can only imagine where interest rates would be if the deterioration of Europe hadn’t coincided with the end of QE2.

I’ll keep making this point in light form since I will clearly need to make it many, many times.

The interest rate on US debt simply is the projected future path of the Federal Funds rate. What the private market thinks is wholly and completely irrelevant.

There are many ways to think about it but the easiest is this: as a bank it is always a better idea to loan money to the government than to loan money to anyone else. This is because the Federal Reserve sets the price of loanable fund by trading T-Bills.

If the for some reason the Funds Rate fell below the T-Bill rate you would simply borrow in the Funds market to buy T-Bills. This would raise the Funds rate which the Fed would then lower by buying your T-Bills.

The point of QE is in part to push money out of the Treasury market into somewhere else.


In the wake of my initial posts on climate change Brad Johnson asked me to grapple with a number of different articles on the subject.

I think this is a conversation worth having but my core issue with the discussion’s current state is summed up in one of the pieces Brad points me to. Its entitled: Why two degrees really matters.

The problem is that it doesn’t actually tell us why 2 degrees matters. It tells us stuff like this

The warming-limit approach is analogous to how businesses conduct planning under uncertainty: Set a long-term goal, then work backward to determine how to achieve it, modifying plans dynamically as developments dictate. It’s operationally much more useful than a target for a single year. In fact, it can be used to derive such targets over many years, once the budget is allocated to developed and developing countries. It also has advantages over conventional, forward-looking policy analyses, which are hamstrung by the inherent limitations of economic forecasting models in accurately predicting the future.

Which is to say a lot of the discussion revolves around at what rate the planet is warming, what various emission targets would or could produce in terms of warming limits, etc. However, what I would love to get to center the conversation around is what we think is actually going to happen when the as the planet warms.

This is especially true, because I hear talk of apocalyptic scenarios bandied about. I am certainly not shy about apocalyptic thinking and analysis but to do it, we actually have describe the event chain that leads to the apocalypse.

If we can do that, we have something to work with.

Now, I am sure that someone, somewhere has done this. It would be helpful to get a pointer in that direction. As I said, I worked with the old Nordhaus models. I know those damage functions. I also know they are not really dynamic.

Nor, where they meant to be. These types of models were trying to bound prices on carbon. However, if we want to think about disaster, we have to talk about disaster.

In passing I’ve seen what look like suggestions that European banks could simply buy debt from their home countries and park it at the ECB. Thus, arbitraging the difference between the overnight rate and the rate on sovereign debt.

In its simple form, however, this will not work because the Sovereign debt is marked-to-market. Thus, if you buy primary bonds at 3% but they then trade in the secondary market at 6%, the value of the bonds as collateral at the ECB will decline to the 6% price, which on top of you have to take a haircut.

This dynamic is actually why you can have well subscribed auctions for Italian debt, but at very high yields. Its good stuff to have but only at the price it trades at in the secondary.

In order to keep this backend problem from biting the bank basically needs to make a commitment to the government that is big enough that it calms market fears about the ability of the government to roll over debt.

However, if a bank can make such a guarantee then the market yield on primary and second debt will collapse.

So, you actually need some sort of scheme to profit from this arbitrage. You need to be able to capture the yield decline that comes from making the Lender of Last Resort guarantee.

This type of scenario is what I tried to sketch here.

Via Kevin Drum, the BBC has a feature in which some of the worlds “top economists” show their “most telling” charts regarding the financial developments of the last year.

Conspicuously absent is this chart:

[Courtesy of Marcus Nunes]

Europe is facing what is fundamentally a money demand crisis caused by a passive tightening of ECB monetary policy. This is due to the insane notion that the yard stick of success price stability, come hell or high water. This is the reason that a crisis is manifesting itself in countries whose fiscal position prior to the recession was not particularly bad.

Via Reihan Salam, Charles Blahous has a piece that mainly centers around the to what extent social security can be claimed to be self-financing. However, in build up he makes a point that I want to respond to.

The ongoing effort to partially convert Social Security from payroll-tax-financing to income-tax-financing – by further cutting the payroll tax as a stimulus measure and replacing the funds with general revenues – may in short order put an end to the longstanding conception of Social Security as a benefit earned by worker contributions. The demise of this conception would also threaten the special political protections Social Security benefits have long enjoyed.

Most Americans do not know all of the details of Social Security finances. They do, however, retain a strong sense that Social Security participants somehow paid for their benefits, and that the program’s Trust Funds represent “their money” in a way that the financing for other government programs does not. This sense gives Social Security benefits an extra political protection relative to other programs. It would likely end if we abolished the Social Security payroll tax, did away with its trust fund, and funded the program with general budget revenues.

This is the type of thinking that I tend to waive away with typical Smithian insouciance.

Social Security – I would argue – has a special status because it cuts checks to old people. Old people are popular. Thus, Social Security is popular. How it is accounted for is of no significance.

What’s nice about this, however, is that we are likely to find out. Charles is almost certainly right about the trajectory of financing.

With a sociopathic insouciance that I strongly approve of, Matt Yglesias suggests that the essence of manufacturing (vs services) is putting stuff in boxes and that’s not really something anyone should care about.

Kevin Drum disagrees

There really are some good reasons to care about manufacturing jobs. Here are three:

  • The manufacturing sector is generally more capital intensive than the service sector. Because of this, a pea canning factory can afford to pay higher wages for unskilled and semi-skilled labor than a restaurant can.
  • On a related note, manufacturing facilities are generally more scalable and more amenable to technological improvements. This improves productivity, and improved productivity is key to improved wages. By contrast, the restaurant business doesn’t have a lot of scope for automation or productivity improvements.
  • Manufacturing is part of the tradable sector, while service industries generally aren’t (though there are exceptions). A pea canning factory can ship its products overseas and help maintain our balance of payments. A restaurant can’t.

So, none of these things are necessarily true.

Sweatshops tend to be highly labor intensive. A radiologist’s office is highly capital intensive.

The West Edmonton Mall is about 3.8 million square feet. That’s about the size of GM’s largest facility, Arlington Assembly. Though, admittedly both are dwarfed by River Rouge, which at its peak claimed 16 million square feet of floor space and was a thing of beauty:

Still, the Abarj Al Bait Towers in Mecca claims 16.7 million in floor space. Though, it contains residential as well as shopping and hotel, so its not really pure “service” facility in the same sense.

Virtually all services are tradable. You just need to move the customers rather than moving the goods. When Euro hit highs just before the crisis New York stores experienced an influx of European shoppers.

What is important, however, is this: putting things in boxes raises the catchment area for most facilities. The fact that there is a box involved means that I can service customers all over the world. That in turn means that a manufacturing facility can benefit from the type of agglomeration effects that services often depend on cities to achieve.

This is also why hotels tend to be the largest and most capital intensive consumer service facilities. They are catching tourists from all over the world. Clearly, that’s also why it makes sense that the very largest of them all is in Mecca.

The decline of manufacturing is the fundamental reason why some economists predicted the rise of the city. To achieve the same scale affects people would have to be in close proximity to one another.

In the near term they seem to be right, though I still hold on to the notion that cheap energy and telecommunications will reverse the trend and allow services to be provided from anywhere.

In any case the key question, as it has been for hundreds of years, is the extent of the market and how much specialization and capital intensity that allows. Putting things in boxes gives manufacturing an advantage but not an insurmountable one.

If you were convinced by Tyler Cowen that we are facing a Great Stagnation, but like me you found his recommendations incomplete and on the short side, then Alex Tabarrok’s Launching the Innovation Revolution is a logical follow-up read. A lot of books get discussed in the blogosphere, and even if you’re the kind of person who reads the reviews on blogs rather than the books themselves, I highly recommend it. It’s short and extremely readable. I finished it in 1.5 sittings. And as Tyler says, Alex is a good tracker of truth, so you don’t have to spend a lot of time and energy figuring out why he’s wrong about something that doesn’t sound right.

There are three main areas of reform he recommends to help our economy grow faster in the long-run: education, patents, and immigration. I can’t disagree with the three categories, in fact immigration and intellectual property were the two categories for gains I suggested were missing from Tyler’s book in my review.

The area that I think begs the most questions is the one on education. Alex argues that there is a strong relationship between a the education levels of a country’s citizens and productivity. “[I]ncreasing the quantity and especially the quality of education”, he argues, ” has potentially enormous payoffs”. I don’t find this very controversial, but how much is there left to gain here for the U.S.? Now I would agree with Alex that are trillions to be gained here, but I am skeptical of the particular low-hanging fruit he identifies:

Average education levels have not stagnated because of fewer PhDs (although as we shall see that is also a problem) but because fewer people are graduating from high school.

He draws a line from high dropout rates and low international standardized test scores to the fact that countries with a better educated workforce innovate more and grow faster. But while I agree it is extremely important to improve the educational outcomes of high school dropouts and those who are currently the worst off, I don’t think raising the productivity of these workers will strongly affect our innovation. This is also why I’m skeptical of basing expectations of the impact of improving outcomes for U.S. high school dropouts on estimates from studies of the effect on average educational outcomes on productivity. My guess is that increasing educational outcomes for the the top two quintiles has a strong impact on overall productivity, while increasing outcomes for the bottom does not have nearly the impact.

In his immigration section Alex nicely lays out the mechanism by which high skilled workers generate spillovers via idea creation. In his innovation section he talks about how inventions build on each other, so an invention today can generate positive returns going far into the future. Given these mechanisms it’s not hard to imagine how increasing education for the top quintiles can increase rates of economic growth. And while it isn’t hard to imagine significant level impacts from increasing education for the lower quintile due to positive spillovers like less crime and higher low-skilled worker productivity, what are the comparable mechanisms for increasing rates of economic growth?

I am not a hardened skeptic here, I am open to persuasion. And like I said I think increasing educational outcomes for high school dropouts is one of the most important things we should be doing. But I do not see a convincing growth argument tied to the rest the themes book.

Another more minor question I’d raise is with respect to teacher quality. Alex argues correctly that we currently pay teachers for experience and advanced degrees even though they are not strongly related to teacher quality, meaning they do not raise value-added test scores. But Alex also argues that teacher quality has decreased over time as measured by high school rank, college selectivity, and SAT scores, and that we should care about this. But is there strong evidence that all of these measures of ability are any more tied to teacher effectiveness than the credentialing and experience Alex criticizes? Matt Di Carlo at the Shanker Institute argues that “it’s very tough to predict teaching effectiveness based on teachers’ measurable pre-service characteristics”, and “when there are associations, they tend to be inconsistent and small”. I think there is an argument to be made that these are at least somewhat useful measures of teacher quality while credentialing is largely not useful, but I don’t think Alex makes the case in his short education section.

But enough on disagreement. I particularly agreed with and enjoyed his section on immigration, and I think reforms there have the most potential to increase economic growth rates. This is especially true because reforming immigration is so easy: just let them in. In contrast, selecting the right innovation policy is more complex:

“No single institution solves all problems. Patents, innovation prizes, patent buyouts and advance market commitments all have their place. The key is to match problems to institutions.”

This is a much more challenging problem than simply liberalizing high-skilled labor markets. Immigration policy that is of an order of magnitude better than what we have in place now is comparatively simple problem when examined next to patent reform.

Overall, you should read Alex’s book. You should have been reading it now instead of reading this review. I hope it is influential.

The Obama administration’s attempts to regulate for profit colleges are reportedly being “watered down” under pressure of lobbyists and the industry:

Last year, the Obama administration vowed to stop for-profit colleges from luring students with false promises. In an opening volley that shook the $30 billion industry, officials proposed new restrictions to cut off the huge flow of federal aid to unfit programs.

But after a ferocious response that administration officials called one of the most intense they had seen, the Education Departmentproduced a much-weakened final plan that almost certainly will have far less impact as it goes into effect next year.

Maybe “much-weakened final plan” is in fact  watering down good regulations as a kow-tow to political pressure as a former Education Department official who helped shape the original plan claims. Or maybe the administration “listened to what they viewed as reasonable arguments and decided to narrow the scope of the original plan” as Cass Sunstein claims. Maybe it’s a little of both. As far as I can tell from the article, this is the meat of the changes:

The final standards leave a maximum of 5 percent of schools facing financial sanctions at the start; the original plan would have meant penalties against an estimated 16 percent.

The rules also pushed back the penalties to 2015 from 2012, while requiring schools to disclose more data about loans, defaults and job placement.

My gut instinct is that this constitutes watering down, but I’d put very little weight on that. What seems clear to me is that the original form of the new regulations as envisioned by the administration contained a much more egregious and much larger “watering down” in the application of the regulation to for-profit schools only, rather than both for-profit and non-profit. On what basis can one justify this exemption?

One can argue that the for-profit sector vastly underperforms the non-profit sector, and thus is the one in need of stricter standards. But it seems hard to argue that 1) standards have been designed to affect only underperforming colleges 2) non-profit schools aren’t underperforming, and 3) subjecting non-profit schools to the standards would affect them. If subjecting them to the regulations will harm them, then they are underperforming. If they aren’t underperforming, then subjecting them to regulations won’t harm them.

I think mood affiliation makes some people instinctively see for-profit schools as bad and deserving of attacks, and non-profits are good and deserving of praise. Diane Ravitch is the exemplar here. The popularity of this bias explains why the egregious exemption of non-profits from this law can exist. This is why people see the extremely low graduation rates of some for-profit schools and declare with outrage that they are failing and in need of major reform, and yet look at the sky high dropout rates at our nations worst public schools and scoff that teachers can only do so much and that poverty is the real problem. (I will let someone else write a post drawing parallels between this law and NCLB and highlighting inconsistent criticisms therein, but suspect it is a rich topic for exploration.)

To a lesser but still real extent, I think mood affiliation bias probably makes it easier for some on the other side to acknowledge the extent to which socioeconomic status should be considered in school performance measures when the class of schools we are talking about are largely unregulated for-profit corporations and not union dominated public sector institutions.

This is not to say that one must have equivalent scorn or praise for the worst for-profit colleges and the worst public schools, but that the extremeness, starkness, and gut level of these reactions is problematic.

Mood affiliation is everywhere in education, and it will continue to hold back real reforms.

So to start Tyler is saddened that no one took up his initial post on the issue where he says

Draghi says yes to loans to banks, for a three-year period and with weak collateral, and no to loans to sovereigns, in accord with current EU law.  (Admittedly his remarks requirefurther parsing and so this interpretation is subject to revision.)  What does the Modigliani-Miller theorem say?

A cash-strapped government will start a bank.  A cash-strapped government will induce a domestic bank to lend more to it.  A cash-strapped government will force a domestic bank to lend more to it.  Remember the era of “financial repression”?

To some extent governments will internalize the value of this guarantee to banks.  If you don’t think this guarantee to banks somehow transfers to governments, won’t ECB-guaranteed claims on the bank become the new safe domestic security, knocking out the market for the riskier sovereign stuff and thus mandating some kind of risk equalization to keep the whole show up and running?

If its any consolation I would have commented but was busy with other things.

I wouldn’t think of it the way his second paragraph reads, but this relates to what I’ll talk about below.

I am not sure I know what he is getting at in the third paragraph but right off I would say that there is no sensible “domestic safe security.” What matters are the securities available inside the Eurosystem. Now, it is true that there were problems in the money markets and for a while in equalizing effective money rates under the various National Central Banks, but solving that problem doesn’t alter the dynamics in a way that I see “knocking out the market for the sovereign stuff”

In any case what can we do with the 3yr loans to the banks.

Well, we can produce essentially unlimited levels of liquidity. Now, if you had one bank that was big enough the debt crisis for Italy, at least, would just go away in the near term. I’d have to look at the other countries to see what was possible there.

Here is how.

So, I am the big Italian Bank. First, I just pack up my entire stack of Residential and Business Loans and ship it to the ECB. Procedural details are important here, but if I took no haircut AND if I am paying the overnight rate AND if payment is not due until the end of the three years AND I keep the yield on my collateral then just ship it all. I am sure I don’t get all those things, so the deal is not as good but we can use that as an extreme point to anchor the thought experiment.

So, now I got a bunch of cash.

Then I buy a bunch of Italian debt. I face a tradeoff because I want to move the market as little as possible but I also want to buy as much debt as possible. There is some profit maximizing amount here that balances those two concerns.

Then I sign a deal extending the Italian government a line of credit for three years sufficient to handle all of its financing (this is why I have to be big enough.) at some clearly manageable rate say overnight plus 50 bps.

As soon as I do that, the yield on Italian debt will collapse. The three year and less yield should collapse all the way to the overnight rate. Probably the 10 year will collapse pretty far as well as this steers us towards the “Italy self-finances” equilibrium.

Then I sell all of my Italian debt and make a ton of money.

Now, my big risk is that I have this credit line outstanding with the Italian government. If we get down the road close to 3 years and things start to look like they are going badly then the yield on Italian debt is going to rise and the government will exercise the line. Then if things do go badly I go down completely.

The key question though is whether I am actually carrying any non-existential risk. This is a nice place to link up to the question of “Too Big to Fail”

Because, if things went badly what would probably happen is that the ECB would bail me out and then everyone would whine that the only reason I did this was because I knew the ECB would bail me out. And, we should end “Too Big to Fail” blah, blah, blah.

However, that is false.

The issue is more fundamentally this. If Italy can’t make it with the deal I am offering, then Italy certainly can’t make without the deal that I am offering. However, if Italy can’t make it then the fallout from an Italian default and likely Euro breakup would mean that I couldn’t make it without a bailout anyway.

So, in the world where I get bailed out this loaning money to Italy doesn’t adds limited risk because I will get bailed out. In the world where I don’t get bailed out loaning money to Italy doesn’t present much risk because if the fundamentals are bad enough to make this a bad loan then I don’t survive anyway.

Thus, there isn’t a state of nature in which loaning money to Italy alters my survival. Thus, if it may be profitable to loan money to Italy I should do it.

Now, that having been said the ECB could manufacture a state of nature in which loaning to Italy would alter my survival. They would do this by saying we will bail you out If and Only If you don’t loan to Italy.

This is like a conditional bailout which how bank regulating often works. But, absent that, the policy stance of the ECB doesn’t matter because it doesn’t change the consequences of my actions.

Okay, so all of that was with a big enough bank.

The reason it needs to be big enough is so that it can internalize the gains from arbing Italian debt and the ECB lending facility.

You could also have multiple banks that were big enough in co-ordination to do this but they would have to work closely because if you can’t guarantee the line of credit then you can’t buy up the secondary market bonds which means you can’t profit easily from guaranteeing the line of credit.

On the other hand if there were enough Italian banks already holding enough debt to make this scheme profitable then you could arrange it much more easily. You could possibly get some banks from other countries in on it too but it depends on what kind of existential exposure they face with respect to Italy.

However, generally speaking if the size of the banking sector is big enough you make this work.

He says a lot. I’ll try to address piece by piece.

Next, some people have shown interest in this paper by Diamond and Saez. A key result that seemed to get these people excited is the calculation of a top optimal marginal tax rate (including all taxes) of 73%, relative to the current rate of 42.5%. There are two key assumptions that Diamond and Saez make to come up with the 73% optimal rate. First, we should not care about the welfare (at the margin) of the rich people. This argument is based solely on the notion that marginal utility of income is low for the top income-earners. Second, Diamond and Saez use a "behavioral elasticity" of tax revenue with respect to the tax rate of 0.25. To see how this matters, if you use their formula and an elasticity of one, you get an optimal top tax rate of 40%.

This is definitely right. How people respond to taxes is a big deal. This is especially true for the very wealthy.

Now, I know it is fashionable to dump on rich people, but I’m not sure we want to discount their welfare as much as Diamond and Saez want to. Preferences will matter here. For example, if we take internal habit persistence seriously, as some people like to, that could make us want to weight the rich and poor equally, by Diamond and Saez’s logic. I’m not committed to habit persistence, but there may be some features of behavior that are not consistent with log utility, for example. Further, Diamond and Saez are thinking in static terms. In reality, there is mobility within the income distribution, and how much mobility is an important issue here. Given mobility within the income distribution, we all care, for selfish reasons, about how the rich are treated, as we all could be rich some day, or our descendants could be rich.

This argument cuts both ways though and indeed supports higher tax rates. For D&S the “function” of higher tax rates is to ease the burden on lower income folks.

If people might both be lower income and higher income, or have uncertainty about their children’s income then you want more progressivity not less. That’s because progressivity functions like insurance. It helps you when times are bad but hurts you when times are good, thus smoothing out overall fluctuations.

Importantly – and I actually think this is the right way to think about it – it serves as insurance for unborn generations. If your grandchild might be rich then she might also be poor. It would be natural to want to write a social insurance contract whereby we agreed that the rich grandchildren would give to the poor, thus making us all feel more secure about the economic future of our grandchildren.

Though I do think people don’t take into account the enormous assumption you are making when you use log utility and of course my hobby-horse, the separable log. Effects that actual human beings talk about on a daily basis simply disappear automatically when you use that functional form.

Finally, I have no idea where that "behavioral elasticity" is coming from, and I don’t trust it. My best guess is that it includes none of the factors that I think are important in addressing the problem. What we need here is a dynamic general equilibrium model that can take account of the short run and long run effects of a change in the income tax schedule. My best guess is that "behavioral elasticity" means that Diamond and Saez are measuring the effects of tax evasion and the intensive margin of labor supply, and that’s all. If so, I think they miss most of what is important:

I am all about a dynamic GE model but the results don’t sound crazy to me.

1. There’s also an extensive margin. Tax people at a higher rate, and some drop out of the labor force

Its going to be really hard to make the numbers work here. Unless you are raising total taxes then higher marginal rates mean lower infra-marginal rates. You lose the entire thing if you drop out of the labor force.

You really need piece rate workers like freelance writers and actors to get big effects.

2. Taxes affect occupational choice. Some work byManuelli/Seshadri/Shin says that the effect of taxes on human capital is big time. Why do I want to undertake a costly and risky investment for a very small payoff?

Haven’t read the paper but the obvious answer is that the payoff is status. Plumbing pays pretty well and is steady work. I see a lot more 1300+ SAT kids signing up for a Gender Studies major than a plumbing apprenticeship.

3. Entepreneurial activity has to be very elastic with respect to tax rates at the top end. Why would I want to risk my own wealth or that of my close family for a very big payoff with very low probability, if that big payoff is taxed at 73%?

If I teach the blogosphere anything it will be this: NEVER PUT YOUR OWN MONEY IN THE SHOW!!

If God had intended for you to risk your own resources he never would have invented credit markets and compulsive savers. These things exist for a reason – use them.

Here is a short quiz to see what we have learned.

You have a business deal that is *guaranteed* to payoff. If you put in $50,000 and a bit of sweat equity you’ll get back $200,000 in two years. Where do you get the funding

(a) Savings

(b) Mom and Dad

(c) Maxing out every credit card you can find, paying off the balance with cash advances from other cards, pushing your credit limit as high as you can get it and then dumping all the money into your scheme

If you answered anything but (c), then out of the gene pool immediately!


You just failed Optimism Bias 101. Only you and your mom think this plan is guaranteed. In fact this plan will not work. You are not special. Most of your ideas suck. Your understanding of the relevant issues ranges from shallow to non-existent to not-even-wrong.

How do I know? Are you you a person? Well, then.

However, you can succeed using the law of large numbers, if you keep trying and remember this golden rule: NEVER PUT YOUR OWN MONEY IN THE SHOW!!

I have more comments related to entrepreneurship but it is crucial that this point sink in.

4. The United States is highly dependent on highly-skilled labor that migrates here from other countries. With a top tax rate of 73%, the Indian engineers might prefer to work in India, and the Canadian professors might prefer Canada.

Again, its going to be hard to make this work. Remember that high top marginal rates reduce the rates on lower levels. This means that the vast majority of folks are going to get a positive total income effect.


As always I think the big concern that you would want to model is how highly progressive tax rates effect the speed of economic evolution. Its going to mean that the after tax cash flow from more successful operations and capital investing techniques will be less differentiated from  less successful ones. Because internal financing is cheaper than external financing this means slower expansion.

UPDATE: You may ask, doesn’t the concern over internal financing conflict with the golden rule?

If you are dealing with a pure gamble then yes, there is no such thing as playing with the house’s money. Any money you win is yours and you need to treat it as such.

However, with business this isn’t true because there is a huge amount of serial correlation in business success. A business that was successful this year is far more likely to be successful next year than a business that was failing this year. This means reinvestment can make sense even if – importantly – you have no real understand of why this business works. You just need to be aware of the serial correlation and spread between internal and external financing.

I began listening to Mises’s classic, Human Action, on a long drive tonight.

Its “fascinating” on so many levels. I use scare quotes only because at this hour I can’t put my finger on quite the right word.

A few off the cuff reactions

  1. Mises begins by attempting to convince the reader of the importance of epistemology, which of course I agreed with in every respect, though it was “fascinating” that he took some things like polylogism so seriously.
  2. Though so far he is quite careful I do think he errs when he says that no one can justifiably tell another person what will make them happy. Especially when he says uneasiness compels action and action serves to increase happiness. This supplies us with a simple thought experiment: I tell you do something, you do it and then all uneasiness ceases and you stop acting. Have I not then by this own definition told you what makes you happy?
  3. He makes strong delineations between humans and animals that are awkward to the point of being slightly painful to the modern ear. Seemingly suggesting that non-human animals do not possess means-ends reasoning when experiments show us that they clearly do.
  4. He delineates between consciousness and unconsciousness in a way that is not supported by brain experiments. It is not clear that introspective rational thought plays any roll in decision making and it is certainly not fully illustrative. We know this because we can electro-mechanically manipulate someone’s brain into producing an action and the person will then report a reasoned explanation for their behavior which cannot possibly be consistent with our manipulation. This opens the possibility that all reasoned thought as we conceive of it is post hoc rationalization and at minimum some of it is.
  5. Mises has an elegant treatment of monistic materialism, which he presents as just meta-physics. Human Action was published 1949. If I remember correctly Sheldon Glasgow formalized the first version of the Standard Model in 1960. Only 11 years later. Its amazing how fast the 20th century moved.

So far, I really enjoy it and it is brilliant as a work of philosophy and glimpse into the history of human thought.

I did not get to see his press conference this morning but Bloomberg kindly posted his prepared remarks.

In those remarks there is nothing Hawkish and indeed, some quite Dovish measures so I will need to wait until I get a recording of the press conference to judge the market freak out.

However, here are some key points from the prepared remarks

Based on its regular economic and monetary analyses, the Governing Council decided to lower the key ECB interest rates by 25 basis points, following the 25 basis point decrease on 3 November 2011. Inflation is likely to stay above 2% for several months to come, before declining to below 2%. The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks.

I am a Fed watcher and only a recent ECB watcher but this is hella dovish talk for a Central Banker. Basically, dismissing current inflation reads and using terms like “substantial downside risk”

You are saying that you intend to get in front of the ball and this is only the first step. Strong signal to more cuts and if this were the Fed inter-meeting cuts.

Overall, it is essential for monetary policy to maintain price stability over the medium term, thereby ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make its contribution towards supporting economic growth and job creation in the euro area.

Restating the mandate. This is meaningless. Everyone must do this.

In its continued efforts to support the liquidity situation of euro area banks, and following the coordinated central bank action on 30 November 2011 to provide liquidity to the global financial system, the Governing Council today also decided to adopt further non-standard measures. These measures should ensure enhanced access of the banking sector to liquidity and facilitate the functioning of the euro area money market. They are expected to support the provision of credit to households and non-financial corporations. In this context, the Governing Council decided:

Almost complete admission that the European Money Markets were shutting down and that this was going to halt the provision of credit.

Given that this is by definition an absolute failure of monetary policy and a complete loss of control, that you put it in the statement is a big deal. It means that you take it so seriously you are willing to admit that you were on the verge of completely losing control of your currency zone.

I am actually not sure I would have done this. I would have said, “the ECB moves to head off any potential disruptions to the euro area money market.” But, maybe communication culture is different.

First, to conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year. The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures. The first operation will be allotted on 21 December 2011 and will replace the 12-month LTRO announced on 6 October 2011.

Second, to increase collateral availability by reducing the rating threshold for certain asset-backed securities (ABS). In addition to the ABS that are already eligible for Eurosystem operations, ABS having a second best rating of at least “single A” in the Eurosystem harmonised credit scale at issuance, and at all times subsequently, and the underlying assets of which comprise residential mortgages and loans to small and medium- sized enterprises, will be eligible for use as collateral in Eurosystem credit operations. Moreover, national central banks will be allowed, as a temporary solution, to accept as collateral additional performing credit claims (namely bank loans) that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the national central bank authorising their use. These measures will take effect as soon as the relevant legal acts have been published.

If I am not mistaken this seems to be functionally equivalent to the Fed’s Term Action Facility, only more so. We need to see the actual procedure but 36 months. It means you can dump anything now and not have to worry about it for 36 months.

We need to see what happens if the market value of the collateral declines. Are you required to re-up? If not then for the banking system this is basically a full bailout.

Also, originally I thought the ABS (Asset Backed Securities) language was more vague. Remember, you can make ABS out of anything, and I mean anything. Notes from your grandmother. It doesn’t matter. You just need a model of how payments will flow through to the final security. That means that you can mix good stuff with junk and if overall it gets a single A, you can move the junk onto the Central Banks balance sheet.

However, it seems that it is limited to mortgages and commercial loans. Which doesn’t really matter for our purposes because that is the mass of illiquid assets and the heart of banking.

Third, to reduce the reserve ratio, which is currently 2%, to 1%. This will free up collateral and support money market activity. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system ofreserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions. This measure will take effect as of the maintenance period starting on 18 January 2012.

If I am reading this right, we are saying that we are going to cut the amount of collateral that needs to go to the ECB under Main Refinancing Operation in half. Again, a very big step to reducing the collateral crunch.


Overall my initial read on these statements is extremely dovish. I need to see the conference to understand what in full folks are concerned about. However, this looks like what one would do if you were preparing the Euro banking system to survive a major haircuts on sovereign debt.

I have been and am still eager to engage Austrians generally and Hayekians in particular in debates over macroeconomic fluctuations.

This is not because I believe – as many have suggested – that Real Business Cycle Theory over even the Chicago emphasis on micro-foundations are Hayekian. They don’t seem to be to me.

Its because in my mind Hayek’s explanation of the business cycle is a beautiful example of a theory whose only vice is that happens not to be true. Its brilliant. Its elegant. Its parsimonious. It possess boundless fecundity. It’s the kind of thing we expect from brilliant minds. It just happens to be wrong.

And, this is a crucial, crucial, crucial point.

The world is not something that makes sense to us. The world is something that is. Its entirely possible for very beautiful sensible things to just be wrong.

For me, I will say, the first instance of this was reading as a child the debate between the Steady State Universe and the Expanding Universe. Obviously, the Steady State Universe is far more beautiful, far more sensible. It lays to rest dozens of meta-physical questions and produces a model of the world in harmony with our spirit as human beings.

Its also wrong.

I remember so badly wanting it to be true and when I grew up wanting to discover that the expansionist had been wrong. That this theory – the theory that deserved to be true – was true.

But, its not true.

This is painful but its real. And, we have to decide at some point whether we want to bask in the joy intellectually fulfilling views of the world, or whether we wish to see the world as it is, warts and all.

Coming back to Hayek let me take these line from his elegant Nobel Prize lecture on the Pretense of Knowledge

The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity. The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because, as this view is sometimes misrepresented, this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

What he is saying in our modern terms is that mass unemployment is the result of frictional unemployment which in turn result from a distortion of the price system.

This makes a lot sense and in many ways it should be true. But, its not true.

And, we know its not true because when we run the process in reverse we get the reverse result, but Hayek’s frictional analysis would not allow for that. Any distortion in prices should produce frictional unemployment as the economy readjusts.

Yet, in the early 1980s the US Federal Reserve crushed down on the inflation rate, producing immediate unemployment. This is somewhat anomalous from Hayek’s prescription because the initial phase of distortion doesn’t produce contraction. However, let that be.

What really makes the difference is that when the Fed decided to stop, without telling anyone by the way, the economy boomed. Naturally, after such a harsh period of dislocation resources were away from their long run best uses. It should take time to readjust.

However, it took no time. In months the economy was accelerating rapidly and what’s more the inflation did not come back.

Perhaps ironically, I don’t know, we can see why if we sit and pick a part business cycle fluctuations on an industry by industry, even job type by job type level. Resources don’t shift around. New modes of production or ways of satisfying consumer demand are not created at an unusual rate.

Indeed, the rate of creative destruction actually falls during a recession. Fewer jobs are destroyed. Fewer new firms are created.

Most importantly, specific types of production go into hibernation – the building of transportation equipment and the construction of structures. Those workers for the most part move very slowly into other industries, if at all.

And, amazingly when the recession is over they go right back to doing what they were doing before. No change at all. Same cranes, same hammers, same assembly lines. Often the same model lines for the cars and the same blueprints for the buildings.

Its not a shift, it’s a hibernation.

A shift would be more elegant. It would make sense. It should be true.

It just not true, in this world.

Via Suzy Khimm here is a chart on labor’s share of corporate value added.

It’s declining and quite frankly when I look out in the world I see pressure for it to decline further.

This means that real wages must fall. However, for real wages to fall inflation needs to rise. This is part of the problem that the developed world is facing generally.

In addition, this is why folks will be shocked when inflation begins to rise significantly before wages do. The are implicitly assuming this relationship will be stable but it will not be. Inflation will go into supporting ever higher corporate profits.

However, that dynamic is a real dynamic. Stopping it by tightening monetary policy will only spread the suffering and cause more unemployment and slower growth.

Buiter had polar opposite views on the US subprime crisis. I’ll leave it at that. But, we are pretty much simpatico here.

I doubt whether much of the available EFSF resources (whatever they turn out to be) will actually be used to support the sovereigns, directly or indirectly. Rather they will just use enough to allow the ECB to argue that they are acting jointly with the fiscal facility. The EFSF’s resources are more likely going to be used to recapitalise banks and/or to guarantee senior unsecured bank funding (the latter may require some changes in the EFSF framework) in our view. The IMF also will likely come in only with limited resources – just enough to give them a serious say in the design and enforcement of the conditionality. The $400 bn or so currently uncommitted IMF resources plus $100 bn or $200 bn of new money (under the reborn GAB, the NAB, the NNAB or even through increased SDR subscriptions) is more than enough to allow the IMF to be viewed as an entity that has to be taken seriously.

More at FT

I haven’t said much on Europe over the last couple of days. There are obviously lots of talks going on and stress continues in the collateral markets even if bond yields have eased.

However, my gut right now tells me that we are done here. Sarkozy, Merkel and Draghi are signaling more explicitly that they understand they are facing a run and they know how to stop it.

Now, its not that I think they have come to some sudden realization. I am sure they knew this all along. However, they have essentially dropped the credible commitment to be irrational card.

Once, you start hinting that you are not insane you really can’t play that card anymore. So, now the question becomes how far we are going to drag all of this out before the situation is saved. But, you see if we know that in the end we are going to be saved, then to a large extent we are saved right now.

The only thing hanging over our head is the possibility of an event that forces leaders back into their corners, once again being able to commit to irrationality.

So Europe will face recession yes, but the worst case scenarios seem to be moving off the table.

From WSJ

Toyota Motor Corp. said it plans to start exporting about 6,000 U.S.-assembled Camry sedans a year toSouth Korea beginning next month.

The Camrys will be produced at Toyota’s manufacturing plant in Georgetown, Ky. The plant is Toyota’slargest production outside of Japan, employing nearly 7,000 workers.

The decision marks the first time the U.S.-assembled Camry will be exported outside of North America. The vehicles are due to arrive in South Korea beginning in January.

As a side note, this is what a functioning market does when you have spent beyond your means or you’re not as rich as you thought you were.

You produce things that get to be consumed by other people. You don’t shutter factories and send your workers home to eat Cheetos and watch the Real Housewives.

A successful coup d’état is never treason

I did not approve of such brinkmanship but it is now looking ever more likely that the attempt by European elites to hold the world hostage in order to induce more structural reforms may work.

From the NYT

Mr. Monti, who is both prime minister and finance minister, faces the challenge of satisfying the demands of European leaders while making clear to Italians that they must take responsibility for solving the country’s longstanding structural problems.

“The huge public debt of Italy isn’t the fault of Europe; it’s the fault of Italians, because in the past we didn’t pay enough attention to the well-being of the young and the future adults of Italy,” Mr. Monti said. Speaking of his proposals, he said, “We have had to share the sacrifices, but we have made great efforts to share them fairly.”

Among the new measures announced Sunday are sharp cuts to regional governments that could significantly change Italian politics by crimping the flow of patronage spending.

There appears to be little room now for traditional Italian political maneuvering. Though Italy’s economy is the third-largest in the euro zone, it has no forward momentum; economists expect it to contract in 2012 and stay flat in 2013. Meanwhile, the cost of servicing the country’s debts is claiming an ever larger share of its budget.

There has been some chatter about this

Informally, the Fed already has made clear it wants the annual inflation rate to run at 2% or a bit lower over the long-run. A formal statement would codify the commitment. Such a declaration would likely run alongside a description of the Fed’s goals for employment, which Congress requires it to mind along with inflation. Most Fed officials believe the unemployment rate could fall to 5% or 6% without triggering higher inflation.

To articulate its interest-rate strategy, the Fed would expand its quarterly release of the officials’ projections for economic growth, inflation and unemployment. It would add details on the Fed’s interest rate expectations underlying its economic projections, along with some description of the policy it expects to employ to reach its goals.

Since the Fed has been more explicit about its inflation comfort zone it is comforting to here it will be more explicit about its unemployment comfort zone.

However, the primary good of this – I see – is to help solidify political support around the Fed lowering unemployment. Its not the kind of communication vehicle that we would expect to serve as a credible commitment to be irresponsible.

My description of how the private banking sector interacts with the Central Bank and the Fiscal Authorities seems uncontroversial to me. It seem to arise simply from the widely accepted facts about how these things operate.

Yet, I have chatted with several well known economists offline and read much commentary online. The way they talk about finance dynamics implicitly assumes that my model of the world is incorrect. What I’d want to know is where I am going wrong here.

Part of the problem, I know, is that I tend to state things is a non-controversial matter-of-fact kind of way, especially in person. So, what I am saying may escape people.

Let me lay it out then, in a slightly more aggressive form.

Here is the jist.

1) In a modern financial economy overseen by a functioning central bank “savings” do not represent anything real but are merely a residual.

2) When “savings” are placed into a bank that money is effectively annihilated. From a macro-point of view it ceases to exist.

3) In the US economy when people buy T-Bills, that money is also effectively annihilated. It ceases to exist.

4) When banks lend money, money is lent into existence.

5) In the US economy when the government issues T-Bill, money is lent into existence.

6) The financial system thus operates like a big money black box where cash that goes in is gone from the universe, and cash that goes out is newly created in the universe.

7) All of this happens because prices are what connect economic agents in the market and the price of funds is set by the Central Bank. In the US using T-bills. Since, exchange with a bank cannot in-and-of-itself change the price of funds it is effectively like exchanging with a door to the nothingness.

8) Net “savings” affects the lending rates because when people attempt to buy fewer goods and services aggregate demand falls and the Central Bank responds by lowering the cost of funds. Or, conversely when people attempt to buy more goods and services aggregate demand rises and the Central Bank responds by raising the cost of funds.

9) If the central cannot or does not respond to changes in Aggregate Demand then savings is purely money destruction and borrowing is purely money creation.

10) The credit worthiness of bond can be imagined this way: The banking system will dole out funds in an exchange for bonds. There is a ranking of bonds in terms of which will get funding ahead of others. The lower you are on the ranking the worse your credit. At the same time, the less willing the banking system is to walk down the list the worse your credit.

11) The extent to which the banking system is willing to walk down the list depends in large part on the cost of funds which is determined by the central bank.

12) Increases in the cost of funds thus have a double effect on bonds way out on the list because they both increase the base cost of lending and make it less likely that the banks will get to them at all – ie lowers their credit worthiness.

13) When the Central Bank stands as Lender of Last Resort then that automatically moves bonds up to the top of the list.

14) A bond under Lender of Last Resort status from the Central Bank cannot be a poor credit risk unless the total volume of those bonds exceeds the banking sectors ability to lend.

15) Because of all of this any institution – but most interesting from our point of view Central Governments – can permanently extract enormous amounts of resources from the economy without raising taxing or printing money.

16) Because Central Government sits atop the list it extracts resources simply by pushing other bonds down into worse credit territory or off the list completely. This is a process I refer to as bank extraction.

17) This is key because credit wise it is irrelevant what anyone, anywhere might think of the government’s eventual willingness to pay out of taxes or printing money. They cannot be moved from the front of the list and so they will not be denied funds.

18) A central government which strains it banking system through large amounts of bank extraction will see the private savings rate rise and economic growth slow as both private borrowing for consumption and investment are pushed further down the list.

19) The Central Bank could choose to offset this by allowing higher inflation or it could simply allow the private sector to contract.

20) In any case all bond dynamics are completely anchored by who gets money first versus who gets money last and that is almost completely under the control of the Central Bank, should it choose to exercise such control.

To touch on a few things

Carbon Taxes

Its not inconsistent to simultaneously believe that the US should have a carbon tax and that it should aggressively pursue the development of fossil fuel resources.

The point of the carbon tax is to make sure that folks account for the cost of climate change when choosing to consume fossil fuels. The point of aggressively pursuing the development of fossil fuels is to lower their real cost.

Lower real costs are better than higher real costs.

So, the blackboard ideal is to include the cost of carbon in the price of fossil fuels and then support market conditions which lower the cost of fossil fuel extraction as much as possible.

The question is what to do in the absence of a carbon tax. One might suggest that, well in that case we should impede development. That, we should stand in the way of pursuing the tar sands or fracking.

If you believe – as Brad Johnson suggests – that the social cost of carbon are so high that if properly priced people few people would consume it then this makes sense. In this case anything less than the choke price is socially inefficient and so choking off production is always a good idea.

However, if you think that properly priced carbon is likely to have little impact on its use then even in the absence of a carbon tax you don’t want to stand in the way of fossil fuel development. Indeed, you still want to streamline the costs, just as you would if there was a carbon tax.

How Big Are the Damages

Key in this question then is what would have been the right price for carbon. This in turn is intimately related to the damages from climate change.

Now it is important to note that climate change being really really awful does not necessarily mean that the social cost of carbon is high. The social cost of carbon depends on how much worse climate change gets from using more carbon.

For example, if you reached the point where almost all of the bad stuff was baked into the cake, then the social cost of carbon would collapse. Bad things would still happen, but additional bad things would not happen.

In any case I think at this point think the consensus is that we are still on the upward slope where ever more carbon means ever more bad stuff. So, the question is – how bad is bad?

This is where strategic adaptation is a big deal. If you look at the damage function attached to most of the old estimates at least, they essentially measure how much harder it would be to continue our civilization the way it is under climate change.

However, one wouldn’t want to continue our civilization the way it is under climate change. Indeed – and this is the key point that I think is missing – one wouldn’t want to continue our civilization as is anyway.

For example, one of the major costs involved in climate change, is mass migration. Sometimes this is framed in terms of climate refugees. This seems like a big problem. But is it?

If you think think that restrictions on urbanization are a major problem one of the things you are saying is that there is not enough mass migration within the United States. If you think that limits on immigration are a major problem one the things you are saying is that there is not enough mass migration between countries.

Another major issue is Agriculture. But, look at the report from the International Food Policy Research Institute. This shows yield changes under various climate scenarios


For rain fed crops in the developed world you see increases in yields under almost all scenarios and under all scenarios incorporating increased carbon fertilization.

This result is sensible. Much of the developed world is relatively cold and dry. Climate change will tend to make hot and wet. As the authors note when they do their modeling they include no economically driven changes to crop production. They grow crops as they are grown today under simulation of different conditions.

However, of course this is highly unlikely to happen. Increases in yield in the developed world are likely to cause much more intensive farming in the developed would and in part because of technology and capital markets and in part because of the sheer land mass of the developed world, we might expect this to increase total world yields.

It should be noted that right now just about every developed country pays farmers not to farm on currently productive land so as not to let the price of crops fall too low.

A key step in the fight against world hunger is to get first world farmers to stop throwing away production and to make third world inhabitants rich enough to buy that production. The later I argue is preferably done by moving them to the first world.

As always we can and should continue to share information and ideas on this but one of the things that makes the costs of adaptation look higher than they are, is that folks are counting as costs things that are fundamentally good ideas regardless.

Labor force participation has declined the most high school graduates and those with some college. It has actually risen for high school drop outs.

FRED Graph

Compare that to the dynamics of the unemployment rate for these groups.

FRED Graph

Relatively speaking unemployment grew the least for high school dropouts and may be declining the fastest, though the series is very volatile.

Lasting looking at employment itself.

FRED Graph

Here you get the exact opposite effect. The number of employed college graduates has grown while the number of employed high school dropout has shrank.

My off the cuff interpretation was that the economy was shifting towards more and more employment of educated workers, but the growth rate of this shift slowed down.

But that doesn’t seem to be the case

FRED Graph

What that would suggest are shifts in the labor pool. The United States is becoming more educated faster than the economy would absorb educated workers.

Though of course this doesn’t comport with our general sense of the evolution of the economy.

He writes

So on taxes and Medicare, Republicans have made a significant shift. They’ve demonstrated that they really are willing to raise taxes, including taxes on the rich, if it means that Medicare will be put on a sound footing as part of the deal. Given that health expenditures are going to be the main driver of increased federal spending in the decades to come, this is a pretty sensible approach.

Often people want to think like, the GOP believes in this or the Democrats stand behind that.

The Republican and the Democratic Parties, however, are not schools of policy thought. They are political parties. They stand for winning elections.

This is not a dig. They could be nothing else. A political party that does not stand for winning elections will cease to exist.

So the fact that people do not in fact want to dismantle the Welfare State and want to raise taxes on the rich means that at some point it is highly likely that the GOP will support these things.

One interesting issue is abortion. In my long What is At Stake Post, I mentioned that a repeal of Roe vs. Wade would destroy the pro-life movement.

I didn’t simply mean in the simple sense of death by success. I meant that it would unleash a radical pro-abortion movement in America. This is because abortion is a unique issue in which lots of people want to identify as pro-life and support pro-life causes but they don’t actually want to live in a world where abortion is illegal.

If you relate to Bryan Caplan’s thesis on politics the reason for this is simple. Abortion is a gruesome thought. If they don’t have to suffer any consequences from opposing abortion then many people naturally seek to oppose what they find gruesome. However, once it becomes illegal millions of people will be faced with the consequences of this action in that someone they know will not be able to get a legal abortion.

This will almost certainly dampen enthusiasm for the cause. On the other hand people who are attracted to the pro-Choice side will be ever more fired up by witnessing the consequences of illegal abortion.

Now to be clear I say this not as a backdoor attempt to extol the ultimate superiority of pro-Choice views. I actually think this issue brings up extremely deep philosophical questions that virtually no one I can find wants to engage in.

I am just saying this is my estimation of the politics of this issue.

I am not completely up on the politics of this. However, my understanding is that there is to be a Payroll Cut extension but that Dems want to pay for it by taxing Millionaires while the GOP wants to pay for it by shrinking government.

I suggest we pay for it by Issuing 10 year TIPS at just over 0.2% percent real interest and then revisit the issue in ten years.

FRED Graph

Delaying paying for the 119 Billion extension in this way will raise the total cost – including compounded interest – to roughly 120.4 Billion. This is about as cheap as can kicking can get.

Then you raise that 120 Billion on a tax base that is significantly larger. If its not significantly larger then

(A) You have much bigger problems than this 120 Billion.

(B) That implies an economy so bad 10 year TIPS rates will be negative, so you can get paid for kicking the can still further.

One other thing though,

I here that one way thrown around for paying for this would be to deny government benefits to people making over $1 Million. Now in all likelihood most don’t collect any.

However, such a cutoff is effectively a tax increase and if its not phased in is potential a fairly high marginal tax increase on some people. That you call one method taxation and the other method benefit reduction shouldn’t make a difference to people who are actually trying to look at the return to working more.

And as if on cue I am back to questioning this type of assertion from Tyler Cowen

Do not think that Germany has merely to waive a magic wand, or incur a one-time cost, to set things right in the eurozone.  Any “set things right” action on Germany’s part is, one way or another, a form of doubling down.  If it fails it means a bigger eurozone implosion in the future than would happen now, including much higher costs for Germany.  The choice is not “German action vs. doom now,” it is “German action and some chance of even bigger doom later on vs. doom now.” That’s a tough call.  The Germans understand that one better than do most of the bloggers I’ve been reading on the topic.

We want to be explicit about this. What exactly is the way that it gets worse? Maybe Tyler has a scenario, but the worse case endgame for a Euro failure is collapse of the global capitalist system, the political collapse of the West and the end of the Enlightenment.

That’s fairly bad as things go and it could indeed happen. Perhaps, the risk of this happening increases in the future but I don’t see how off hand. If nothing else a richer and more culturally Western China serves as a bulwark against systemic collapse of the Western Project.

I plan to do a more complete reply to Brad Johnson, though primarily as a jumping off point to ramble on about a lot of energy and climate change things that I think.

However, I wanted to address a few concerns right now before I have time to write the longer post.image_thumb4

First and most importantly, while I welcome most of his criticism with open arms Brad did commit a most heinous and unforgivable crime. He broke the hearts of geeky schoolgirls the internet over, by posting a most unflattering picture of me.

Much of the damage is sadly irreversible. Nonetheless, I will do what I can to assure all my pre-teen readers that in real life I am as Bieberlicious as I am clever.

What  this implies for my adorability, I leave as an exercise to the reader.

Even less substantively I want to quickly address a few issues that cropped up around the internet.

1) No, that was not satire. Though, thank you for saying so. I genuinely believe that expanding the production of dirty energy is in the best interest of humanity.

2) I do well with puppies, but find kittens cuter. I like babies generally, though strongly prefer my own. And, yes I do love my mother.

3) Surprisingly perhaps, I am actually not utterly ignorant of the issues involved in climate change. Very early in my career I worked on environmental economics and in particular building the kind of computable general equilibrium models that Nordhaus uses. How that led to where I am is an interesting story, but very much unlike other academics, in my intellectual career building computer models and blogging are the two things that have brought me the most acclaim.

4) I am not really in any sense a conservative economist. Some people have called me a progressive though I don’t take that label either. In all seriousness I feel the most solidarity with what might be called Old Whigs. I am deeply and almost obsessively concerned with the plight of the less privileged, but I am a staunch anti-revolutionary, an unabashed elitist and a skeptic of excess democracy. This is a combination of positions rarely held in the 21st century but more common in the 18th.

5) Tail risk is something we should talk about more. I think people are treating this topic too lightly from a intellectual point of view. Its not clear to me that buying insurance against very deep in the tails calamities is a good idea. The utility functions written down to justify that don’t seem to reflect how people actually value things.

6) Deep uncertainty about the future is a big deal. However, as a rule uncertainty encourages dovishness. There are very specific cases when this might not be true, but generally speaking the more uncertain you are about the future the less willing you should be to suffer today for a better tomorrow.

One can think of it this way. On our last day on earth the best advice is always Eat, Drink and be Merry for tomorrow we will die. It’s the increasing assurance that you won’t die that makes this advice less prudent. Similarly as you become terminally ill you should be more reckless, not more careful.

7) Yes, encouraging people to think short-term is a major theme is lots of my posts because it is the biggest policy mistake I see people making but few people pointing out. To wax Hansonian for just a moment I think the core problem is that thinking long-term is a high status thing to do because smart people are better at it. Thus, being a long-term thinker signals that you are smart. However, as we might expect with status competitions this is overdone. And, because policy choices matter this affects the lives of real people negatively.

Brad Delong suggests that its evidence of weak aggregate demand

What we saw in November, instead, was a 15 basis-points decline in the unemployment rate generated by more people at work. That is welcome. But most of the decline was a 25 basis-point decline generated by a fall in labor force participation. Workers as a group did not become more optimistic about their long-run employment opportunities, but rather less. That is not welcome. It is harder to pull people into employment if they are out of the labor force than if they are in the labor force and unemployed. Hence the fall in the labor force participation rate leads us to mark down the long-term potential output growth path of the American economy.

This has a lot of intuitive appeal, my concern is that when we think about the labor market failing to clear we mean to say that there are people looking for jobs who cannot find them.

If they stop looking this is not obviously a market failure. If it is in fact the case that the real wage is not enough to entice them to work, then they should not work.

If we were seeing a great stagnation, a supply shock, or even certain forms of hangover, this is how it should manifest itself and from a business cycle perspective does not represent any malfunctioning of the market system.

We might feel that this result is unfortunate but then what is truly unfortunate is that the marginal product of labor is too low.

This is going to be a long conversation but I want to stake out my point clearly from the start so when we keep coming back to it you will know where I am coming from

I hold these positions

  1. Climate Change is almost certainly real
  2. Humans are almost certainly causing it with carbon emissions, deforestation and domestication of animals
  3. There will be large environmental costs associated with climate change include a very rapid increase in extinctions
  4. There are likely to be major population dislocations because of climate change
  5. There are likely to be major agricultural shifts because of climate change.

Nonetheless, we should pursue the development of fossil fuels as rapidly as possible including looking for ways to streamline regulation in North American regarding fossil fuel production.


The Immediate Concerns.

  1. We are in the midst of a long Aggregate Demand slowdown in the Northern Hemisphere. This could be alleviated in part by increases in investment demand. Encouraging the exploration of fossil fuels provides this investment demand. It is like free stimulus for the economy.
  2. We have a serious dearth of high paying jobs for middle-brow men in this country. Energy extraction, refining and transport provide a potential attractor for these men. Otherwise we will face serious social consequences from watching the wage of these men fall to minimum wage and an increase in permanent joblessness.
  3. Global growth is constrained by natural resources at the moment, chief among them energy. The speed at which the entire globe can grow is limited by the availability of energy sources and puts us in a rare  zero-sum fight over growth. No, this is not a permanent state of affairs even without fossil fuels. High energy prices will induce development both in energy saving and the production of new sources. But, this could take a very long time and produce a high tension period lasting potentially for over a decade.

Rapidly expanding North American fossil fuel production can help cure us of many of the current ills that we face. If you read me you know that I am very now-focused in general, but over time I will try to convince that this is a really big deal and working class families are really struggling.

There are other public policy solutions that you can find but aside from wage subsidies (which seem unlikely in this environment) and opening up new industries for hard working middle-brow folks there will be little improvement. Health care won’t do it. Improving the schools won’t do it.

Even more importantly, there are hundreds of millions of very poor families around the world right now, who would benefit enormously from lifting the energy constraint on growth. It would allow us to shift out of biofuels which would do a little – though not much – to alleviate the other big natural resource constraint, food.

The Long Run Concerns

The primary concern is that this would make it most difficult to meet our aggressive targets in controlling global warming. I stress, not impossible, because no one can predict the future of alternative energy development. I tend to think solar will come to dominant energy production in a matter of decades regardless, because the fundamentals are becoming so cheap.

However, even if we have to face the warming, we face it in the future with a much richer and more progressive world.

The raw wealth accumulation in third world will make much of the transition cost effective. As global manufacturing leaves China for Southeast Asia and eventually Africa billions of people will be lifted out of poverty. These people will adjust their living patterns anyway. They will build new cities and new infrastructure. If they do it in a way that is sensitive to climate change then there is little marginal cost.

An expansion in global trade production also means that local agriculture becomes less important. Farming will become harder in the Congo but easier in Russia. This is fine if the Congo has something to sell to Russia. Growth and trade mean that the costs are greatly ameliorated.

Opposition to immigration is concentrated in the older cohorts of most Western Societies. As they die off the younger generation will be more cosmopolitian and more welcoming of immigrants. This means that a large part of the harmful affects of climate change will be mitigated simply because so many people move to North America and Siberia over the next 100 years.

We will lose species, there is no question about that. An effort to capture and catalog them genetically should be done. However, I caution us against putting too much weight on the flora and fauna that we have. The vast majority of species have gone extinct. We are left with a very small set that happen to have thrived in these conditions. Its not clear that they are somehow fundamentally superior to what will come next, and of course something will come next.

There remains the possibility of geo-engineering. If we really decide that climate change is intolerable there are things we could do to stop it. The very fact that the side effect of energy production is inducing this process tells us how sensitive the climate can be to our interventions. That likewise means that we can introduce other interventions.

Now, we shouldn’t be convinced that we can fine tune the planet. There will always be unintended consequences. However, we should be confident that if things are clearly and obviously much worse for humanity as the world gets hotter we can do something about it. We should not make the perfect the enemy of the good enough.

Lastly, and this will persuade few people but it is important, 100 years is a long time in the industrial age. However, it is simply forever in the information age. There is an extremely high chance that the very nature of human society itself will have changed by that time in ways that render this entire issue moot.

It would be tragic if we sacrificed the wellbeing of poor people today for something that became almost meaningless 100 years from now. Yet, that is precisely what we may be doing.

Karl defends Andy Stern on China by making a claim about economic growth that on the one hand I think is partly true, but I think he overstates the case. His argument is that it is possible for economies to grow too fast in some sense, because economic growth is not the same thing as welfare. You can take too much from current generations in the name of stimulating economic growth.  Karl has made this point in the past more explicitly, pointing to China’s 40% savings rate outside the bounds of plausible optimal savings rate. This much I agree with, or at least I agree that it is possible and worth considering (I don’t know what the bounds of optimal savings are for China, or if they’re actually outside it). The problem is to use this to defend the notion that China can go too fast forever and use their current strategy to one day surpass us in per capita GDP.

The essence of the problem is still is that while China may be growing too fast because of too much savings, they also still owe a lot of their fast to catch up growth. There are still many things that go into determining a growth rate, and many of these things will weigh China down in the long-run no matter how high they keep savings rates.

In fact, one of the things that will work against them is reducing the incentives of their workers by using policies “designed to induce a large degree of suffering on its people today in return for a more prosperous tomorrow”. Any country trying to do this for a long period of time is going to have all sorts of problems. Look around at all the richest countries in the world, do you see any of them that have anywhere near the level of active management of the economy that China does without oil wealth that is massive relative to the rest of the economy?

Given China’s current level of per capita GDP ($4.3k in PPP terms), sustained large growth rates are not surprising or unprecedented. If China were as rich as we were, it would be unprecedented. China would have invented a brand new model of large developed nation that can grow extremely fast forever. There is a reason such a model does not exist: being a rich country requires democracy, freedom, innovation, entrepreneurship, and citizens who are willing to work. The ability to impose extreme levels redistribution to future generations like Karl is talking about cannot exist alongside all of these other things.

China will reach a limit to healthy growth using their current economic model. When they do, if they wish to keep growing they will look around and realize that their only choice is to become more like the rich world. If China wants to be rich they must learn from us, and Andy Stern is wrong to suggest the opposite is true. Reihan put this best:

To really learn from the Chinese, and to enjoy such staggering growth rates, we should go about things differently: let’s have a Maoist insurrection followed by a civil war that lasts for several years. Then let’s destroy most of the wealth in the country, and drive out millions of our most enterprising and educated citizens by launching systematic terror campaigns during which millions of others will die in violence or of starvation. Next, let’s have a modest economic opening in coastal regions: impoverished citizens will be allowed to launch small-scale township and village enterprises and components will be assembled in a handful of cities by our stunted descendants. Then let’s severely curb those township and village enterprises because they represent a potential political threat and invite large foreign multinationals and state-owned enterprises [let's not forget those!] to work our population to the bone at artificially suppressed wage rates, threatening those who complain with serious reprisals up to and including death. Let us also initiate a population control policy designed to improve our dependency ratio for a few decades. As large numbers of workers shift from low-value agricultural work to manufacturing, we will experience … rapid growth! Mind you, getting from here to there will involve destroying an enormous swathe of our present-day GDP.

None of this detracts from Karl’s point about the possibility of growing too fast in a way that does maximize welfare. It’s an important point about today’s China that is worth understanding. But neither does Karl’s point disprove everything economists know about what it takes to be a wealthy nation.

Andy Stern suggests that America should emulate China

While we debate, Team China rolls on. Our delegation witnessed China’s people-oriented development in Chongqing, a city of 32 million in Western China, which is led by an aggressive and popular Communist Party leader—Bo Xilai. A skyline of cranes are building roughly 1.5 million square feet of usable floor space daily—including, our delegation was told, 700,000 units of public housing annually.

Meanwhile, the Chinese government can boast that it has established in Western China an economic zone for cloud computing and automotive and aerospace production resulting in 12.5% annual growth and 49% growth in annual tax revenue, with wages rising more than 10% a year.

For those of us who love this country and believe America has every asset it needs to remain the No. 1 economic engine of the world, it is troubling that we have no plan—and substitute a demonization of government and worship of the free market at a historical moment that requires a rethinking of both those beliefs.

I’ve seen a tendency on the blogosphere to dismiss Stern for the wrong reasons. Rebuttals tend to note the fact that China is engaged in catch-up growth, or that China is still poorer than the United States.

However, these miss the point. If China continues along its current trajectory it will almost certainly surpass the United States in GDP per capita and consumption per capita. There is also a fair chance that it will end up with a more egalitarian society. It will be both richer and more evenly distributed in wealth. Which is to say simply further out on the social possibilities frontier.

How will China be able to accomplish this?

Quite simply by extracting utility from its current citizens in order to pass on to its future citizens. The policies that China have in place are designed to induce a large degree of suffering on its people today in return for a more prosperous tomorrow.

This is not a tradeoff that people on their own would be willing to make. Indeed, simple back of the envelope calculations will show that China is devoting more resources to investment than could possibly be “socially optimal.” Socially optimal in this sense is an economists blackboard estimate of what an all-knowing benevolent dictator would do.

However, it is a tradeoff that will make the country wealthier.

I point this out because there is an enormous amount of confusion on this matter emanating from all circles.

From where I sit it looks as if people perceive that there are good economic policies which will produce good economies. However, like all things in the real world*, policies and economies unto themselves are not good or bad, they simply are. This is crucial because mechanical and logical relationships exist in the real world which is devoid of concepts “goodness.”

Goodness exists in the human sentiment, which is not subject to the same kind of mechanical and logical relationships. This is why mixing sentiment and reason, such as saying good economic policies lead to good economies, comes out garbled and wrong.

There are things you can do that produce growth but do not increase consumer surplus. There are things you can do which lower unemployment but do not increase consumption. There are things you can do which increase the total wealth of society and the present value of all future consumption but do not increase wellbeing.

Because of this you have to be specific about what it is you actually want to do. If what you want to do is grow your economy as fast as possible then adopting much of the Chinese model is the correct thing to do.

If you are concerned about maximizing consumer surplus then there are times when you wouldn’t want to do fiscal stimulus for example, where you would want to do fiscal stimulus if you were trying to maximize wellbeing. And, of course you would do it even more often if you were trying to minimize fluctuations in unemployment.

What we want to be careful to do is to lay out the consequences – as best we can see them – from our various actions and then pick the one that look the best. Sometimes this means that people will actually want to sacrifice consumer surplus in the name of lowering unemployment.

Indeed, I rail against China type tradeoffs on a near daily basis but it is in fact the case that most people seem to want to sacrifice wellbeing in the name of economic growth, in which case they will find themselves attracted to China’s model.

I am opposed to such a model, but not because I do not think it cannot achieve its own ends but because I think its ends are not worth achieving. Sacrificing the wellbeing of actual living people for some goal about the future, which itself may or may not be that important to the people living then, is something I am extremely skeptical about doing.


*Some of my friends at home would insist that I be more specific about this real world of which I speak. This is a conversation I would love to have but it of course detracts from the economic point even further than I already have. In brief, however, I can say that there are sensory experiences and there is a a narrative written by the mind on those experience. The grammar of the narrative is logic. However, logic is not the grammar of sentiment.

So the sensory narrative can run in conflict with sentiment under the rules of logic. What is key is that the sensory narrative is dominant. For most people there are sensory experiences which no sentiment can overwhelm.

In less abstract terms one might say our capacity for self-delusion is limited and this is why it is practically speaking impossible to occupy a world built entirely in the language of sentiment.

From Market Watch

Overall, the industry reported a SAAR (seasonally adjusted annual rate of sales) of 13.6 million units, according to Autodata, up from 12.28 million in November 2010. Total deliveries rose 13.9% from a year earlier

This is actually a little slower than I was intuitively expecting. Fleet sales are easing more than I would have thought.

A surge on the more-profitable truck side bodes well for GM as does a move away from the lower margin business of selling vehicles to rental car companies and other bulk buyers.

Retail sales rose 15% while fleet sales dropped 14%.

It will makes a 14 Million SAAR December look less likely but though still not impossible.

Again, were it not for Europe the US economy would be poised for explosive growth.

The first is by Mark Perry, who I will start by saying, is one of the few econ bloggers who seems to appreciate what a huge deal North American fossil fuels are to the future of working class people. That having been said he also says

The recovery of both output and profits to above 2007 levels with 6.6 million fewer workers could explain the sluggish job growth that will probably continue for several more years.  If companies can produce more output now than in 2007 with fewer workers and record profits, where’s the incentive to hire more workers? 

This is the Lump of Profits Fallacy that I hear all the time and it drives me insane. What’s the incentive to hire more workers? To make ever more profit!

There is no “enough profit.” More is always better. More profit yesterday. More profit today and still more profit for breakfast tomorrow.

As I have said to associates before: If you ever find yourself thinking “maybe we have made enough money” stop. Reflect on how you feel at that exact moment. Commit that feeling to memory. Because that is how it feels to be completely and utterly wrong in every conceivable way.

The only thing that irks me as much as this, is the “search for yield” meme. When people want to claim that because interest rates were so low we had to go out and look for ways to make yield.

Really? Because normally you just let ways to earn yield pass you by?

If someone honestly told me that he threw my money away because “well we were already earning a descent return as it was” I just can’t imagine what I would do that person. I’m enraged just writing about the hypothetical possibility.

As part of a long theme I want to push back against the notion that “confidence” is a meaningful driver of macro-economic outcomes.

I don’t mean to simply join in bashing the “confidence fairy.” I mean all notions of confidence: investor confidence, animal spirits, consumer confidence, etc.

At the heart of my position is that Aggregate Demand is not practically constrained by what people want to do. Its constrained by what people can do. Put another way, the preferences of consumers and businessmen mean almost nothing. What matters is their budget constraint.

The simply explanation is that in a world of 7 billion people and a country of over 300 million there is ALWAYS someone who wants to buy more, invest more, expand, etc.

We could be in the middle of a Great Depression, we could have marginal tax rates of 70%, we could have a police state that randomly ransacked people’s houses, stole their possessions and carted them off to jail.

Even that world, there is some outlier for whom the only thing stopping him or her from trying to build a vast business empire is that he or she can’t find the financing.

If you doubt this look at the market for criminal enterprises, where the state is explicitly trying to stop you from doing business. Not taxing you. Not regulating you. But, men with guns are coming to either shoot you or put you in a cage for the very act of being in business. Yet, crime never wants for lack of entrepreneurs, though it does sometimes want for lack of financing.

You can call this reverse Malthusianism. The desire of the expanders to expand is always exponential. In the end you only need one of them and they will attempt to take over the entire economy. What’s stops them is competition, scarce real resources and financing.

Thus if you are in a world where no one else is looking to expand, and real resources are slack, financing is all that’s holding one of these folks back.

Practically speaking the price of slack resources also matters because if they actually collapsed in price then at some point you could simply self-finance your empire.

But, there is never a shortage of empire builders. There is only a shortage of people willing to lend to empire builders.

Now, some would say, yes but don’t you need consumer demand nominal and real. That is, don’t people need to have the money to buy your stuff and doesn’t your stuff need to be worth buying.

Nominally, no because the expansion of business itself creates the purchasing power that allows people to buy your stuff.

Real, no not either. Its entirely possible that you could be running an economy where the vast majority of people were employed by businesses who were failing and then replaced by new business who also fail. What you would experience would be a decline in TFP, a rise in inflation and a fall in the real wage as most people would be producing things no one wanted to buy.

If people genuinely couldn’t find good ways to employ resources then everyone would get poorer but as long as financing is available there need be no recession.

He lists a number of reasons to think the German position is better, in the sense that it is better that people are polite than that people are rude.

Two are especially well taken

4. We did a deal with East Germany, and the terms of that deal violated a lot of precepts of economic theory.  It even included an overvalued currency for the poorer region and a long period of adjustment.  Yet we insisted up front that all dealings be done on the terms of the more successful region and culture, with very little compromise.  This transition, for all of its short-term flaws, will go down in the history books as a great long-run success.  In part it succeeded because it was all done on the terms of the values of the successful nations of northwestern Europe.  (I am surprised that this angle is not discussed more in the press, given Merkel’s own story.

This doesn’t exactly accord with my sense of the union, but this is precisely the type of argument I would want to here. Here we are saying that we stuck to West Germaness in spite of calls to do what was expedient and actual human beings judge themselves to be better for it.

7. If you are trying to estimate the future economic fate of a country, shouldn’t you put aside a bit gdp drops and the like, and instead look at what do people in that country esteem and which values are transmitted by their system of education?  Do read the Estonia story at the previous link.

Tyler may be making a slightly different point then what I would take away from this, especially after reading the link. However, there is the important question of to what extent imposing German institution will induce value changes that are themselves preferable to the people changed.

Not simply on an economic basis, but on the question of “I am happier that I live in a society which esteems these things”

This tied up with the deep question of how innate values are and whether or not there are meaningful meta-values. That is, can I say “I wish I was the type of person for whom honesty was important” and mean something by that phrase.

Are you merely making a statement about your hyperbolic discount rate or are there more fundamental preferences over preferences at work?

In any case it is all well taken.

Draghi assures us, not quite yet

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

This is the very important monetary policy reason for the ECB’s non-standard measures. But of course, such interventions can only be limited. Governments must – individually and collectively – restore their credibility vis-à-vis financial markets.

Tensions in sovereign bond markets have been accompanied by stress in the banking sector given the financial interlinkages between governments and banks. The ECB has taken several measures in 2010 and 2011 to ensure that banks continue to have access to funding sources. This has enabled them to continue lending to firms and households.

See Izabella Kamniska for some of the important details.

Let me give you the briefest of rundowns from a American Fed-centric perspective. Though this is all still hazy in my own mind.

In normal times banks lend overnight money to each other without demanding any collateral. This market is the crux of the financial system. In the US its called the Fed Funds market. In Eurozone, EONIA.

Monetary policy usually revolves around managing this market. However, in stressful times this market can breakdown. This is problem number one.

However, things still workout because a variety of repo markets are still working to provide liquidity. These markets, however, require collateral. This is usually government bonds.

However, when collateral is falling rapidly in value the private repo market can begin to shut down.

Luckily you have the Central Bank repo market, where you can always go and get funds. That is, if you have collateral. So, now you face a situation where individual banks might need to borrow collateral in order to take it to the central bank.

Here in lies the major shut down. If people will not let you borrow collateral, because they distrust that you will give it back, etc, then you may not have anything to take to the central bank. If you don’t have anything to take to the central bank, you can’t get Euros.

As this possibility sets in both the interest rate on borrowing collateral and the amount of cash you have to set aside in case the transaction goes bad goes up. The combination of all of these things is your true Marginal Cost of Funds.

As your marginal cost of funds rises this is effectively monetary tightening. Yet, it is not managed by the central bank it is managed by the repo and securities lending markets.

Now, its bad enough for this to go down and there to be a general credit and collateral crisis. What makes it worse is that in Europe, collateral seems to have a particularly hard time moving across borders because there is a lot of distrust and institutional confusion.

This means you can have a massive collateral shortage in Italy, and a huge marginal cost of funding for some Italian banks. While Germany can be absolutely flush in collateral.

This is also why you can see heavy demand for Italian bond auctions even at an elevated price – people need the collateral but cannot pay more than the market-to-market value for it in the secondary market. But, see a German auction fail at low rates. Because at the current market-to-market rates you are actually losing money holding German bonds as a bank. You might as well sell it and then park your cash in the deposit facility.

Only buy-and-holders really needs Bunds at this point and remember what I said a while back about the marginal bond being sold as collateral for repos.

Now. why was yesterday such a big deal. The lowering of the interest rate was perhaps just for show, although it could encourage more use of Central Bank swap facilities than private swaps.

What really mattered is that the ECB lowered its collateral demand from 20% to 12% thus freeing up more collateral. This could ease the credit-collateral crunch in the Periphery in general and Italy in particular.

More generally the ECB somehow has to ease the collateral crunch so as to bring marginal funding for all areas bank into harmony.

There should be some solution that involves the German government rapidly expanding its outstanding stock of T-Bills. For example, massive tax cuts in Germany funded by short term borrowing. However, that is clearly seems like the type of thing that is off the table.

What seems possible but I have a hard time working is that there might be someway to flood the entire Eurozone with dollars, so Euro funding could be provided by entering in EUR-USD swaps with low collateral requirements.

As always the institutional details are important but it seems to me that the Fed could define a special type of Asset Backed Security that took a specific mixture of European traditional bank liabilities from various countries. Specifically demanding a certain combination of liabilities from Periphery countries.

Then it could open a facility to take that ABS from American banks over a long term like two years or so. This would create demand for Periphery banks to unload their traditional bank liabilities onto American bank for dollars.

Now obviously this pulls an enormous amount of risk on to the Fed. However, its not clear that there is any true risk involved here because the risk associated with a complete shutdown of the Periphery banking system is nearly existential.

More importantly, the negative consequences for US tax payers from such a freeze are extremely high so its not clear that their net exposure has gone up.

This is the odd thing about banking crisis that I need to at some point write more fully about. When you think about risk you have to think about what are the possible worlds that you could end up in.

Well, if the world in which you don’t loan someone money is worse than the world in which you do loan someone money and they don’t pay you back, then there is no risk associated with loaning them money.

The issue is that there is an externality problem because if there is someone else who could loan that person money and avoid the super-bad world, that is obviously preferable. So no one wants to loan up to the optimal amount.

Everyone would prefer any world in which this loan is made, yet everyone would prefer a world in which someone else made it.

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