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Adam, argues that occupational licensing is an issue that conservatives, liberals and libertarians can all rally around. Even if we don’t agree on exactly what needs to be done we can agree that this is an issue worth pursuing. Let me count the ways.

At present we have painfully high unemployment. Some Fed officials have argued that this is largely structural. I have suggested that structural unemployment is not consistent with a smoothly functioning free market economy, at least not when one accounts for geographic disparity. Thus, we should look for market failures.

I have focused on monetary policy as that failure. However, occupational licensing may be a non-trivial contributor. I do not know this to be the case but it is a clear possibility. Adam notes

In his book “Licensing Occupations: Ensuring Quality or Restricting Competition?”, Morris Kleiner uses state-by-state variations in licensing to show that employment growth for a given occupation is 20% higher in states where they aren’t licensed.

If the economy is shifting in ways that would tend to push people into licensed professions then this is a clear market failure that could induce permanently higher unemployment as people expend time and energy attempting to win the license lottery.

At the same time we should explore how much licensing is to blame for the increase income disparity. Liberals are highly cognizant of the fact that income inequality has grown as unionization has fallen. However, Adam’s graph is telling

What we have seen is not just a decline in unionization but a replacement of unionization with licensing. Folks on the left and right tend to think of unions as a means of transferring wealth from the owners of capital to workers. However, evidence shows that unions in fact transfer wealth between workers.  Indeed, from both high income and very low income workers towards the middle class.

The idea that unions impoverish the very poor is an important one, but I understand a controversial one, and so I want to set it on the table for now. What we can all agree on is that unions serve to transfer resources from un-unionized executives towards unionized shop floor workers.

On the other hand, licensing works exactly the opposite way. It tends to transfer resources from the unlicensed working class towards the licensed professional class. Thus, we have a swap in market restrictions that moves from what is, at least in part, progressive redistribution to regressive redistribution.

We may not all agree on whether unions should make a comeback, but we can all agree that professional licensing needs to be re-examined. I am not asking for a rush to judgment. I am not asking for pitchforks or hasty conclusions.

I am asking that all parties, conservatives, liberals and libertarians devote time and attention to the issue of licensing. This is not a baseless offer. Resources are always scarce but even here at the UNC School of Government we have expertise and facilities that could be dedicated towards this.

While I am sure that the Washington based think-tanks have to keep much of their attention on “hot issues” in government, I suspect that there is some amount of time that can be devoted towards projects of your own making.

Lastly, I submit that this serves as a jumping off point for Rawlsekianism. The idea being popularized by Will Wilkinson and Brink Lindsey that there is a wide common ground between those who care about free markets and those who care about the fate of the poor.

What I would be disappointed to see would be white papers and academic articles that end up filed away somewhere. We need a conversation between opinion and policy makers on the one hand and academics and think-tankers one the other. I don’t know about policy makers but I know there are opinion makers who read this blog. You have linked to us before.

We need to know policy maker’s concerns. There are those of you out there who are tapped into that. We need to investigate whether those concerns are grounded. Traditional public choice theory suggests that nothing can be done here because concentrated private interest always wins out against dispersed public interest.

I am not convinced.

Much current research says that an elected official’s chance of being reelected extends primarily from broad based economic and social conditions, not the assemblage of narrow interest groups.  Moreover, Bryan Caplan’s research shows that what often looks like interest group politics is really mistaken beliefs on the part of voters.

I am not saying that politicians don’t believe and behave as if their electoral futures depended on pleasing this or that narrow constituency. However, if this is not in fact the case, this is something that policy makers need to be aware of and it provides an opportunity for true improvement in public welfare.

Occupational licensing is a perfect test case for these theories. If it is true that we can reach a broad intellectual consensus on what needs to be done, then whether or not that consensus can achieve results will tell us something about the extent to which narrow interests capture our politics. That in and of itself is worthy experiment.

Its important to remember: more people die from contact with the medical care system than die from breast cancer, prostate cancer and lung cancer combined. Indeed, these numbers are on the conservative end as they count primarily people killed by hospitals.

Numbers on the health care system writ large are hard to come by but some – admittedly controversial – estimates put medical care as the leading cause of death in the US, and by a fairly wide margin.

I often use “Drink Plenty of Fluids” as an example of common medical advice that not only has little scientific basis but might very well kill the patient.

The basic intuition, of course, was that people, when sick, often loose a lot of fluids and may become dehydrated. In turns out that the body is a complex equilibrium system (not unlike the economy) and that dehydration might be exactly what it wants. In particular, in some cases fluid loss is an effort by the body prevent excess build-up in the lungs or brain.

Now Robin Hanson notes the same thing might be true with breaking fevers. While in extreme cases fevers can be deadly, in many (most?) cases they are likely quite helpful and could even save your life

There has … been one randomised trial … in patients in intensive care … In 2005, [researchers] … studied 82 critically ill patients who did not have head injuries or other problems that make a high temperature risky. Patients were randomised to get either the standard treatment of antipyretics if their temperature went past 38.5 °C, or only receiving the drugs if their temperature reached 40 °C. As the trial progressed, there were seven deaths in people getting standard treatment and only one in those allowed to have fever. Although this difference was not quite large enough to be statistically significant, the team felt compelled to call a halt, feeling it would be unethical to allow any more patients to get standard treatment. …

Is it surprising that conservatives don’t complain more about occupational licensing? On the one hand it’s not, because economists themselves don’t seem to think it’s much of a big deal. In their 2009 paper, Morris Kleiner and Alan Kreuger point out that since 2000 no articles on the issue had been written in what are considered some of the top economic journals: AER, JPE, QJE, Econometrica. In the leading labor economics journals, Industrial and Labor Relations Review and the Journal of Labor Economics, only one article on had appeared. In contrast, there were 16 articles on labor unions in just those labor journals. In a survey of five labor economics textbooks Stephenson and Wendt found that occupational licensing took up a combined total of 10 pages, whereas there were 7 chapters on unions. Clearly the profession is neglecting the issue, so why shouldn’t conservatives?

On the other hand, we have the following graph which shows unionization versus occupational licensing using data from Morris Kleiner*:

Over the last 70 years, occupational licensing come to dominate unionization as a labor market restriction, with growth in the former accelerating in recent years. The most recent estimates are that 30% of the labor force is required to have occupational licensing by a government agency, compare to around 13% that are unionized. Estimates of the impact of licensing on wages are about 10% to 15%, which is comparable to the typical estimates of the union wage premium.

So occupational licensing has the same affect on wages and is more pervasive than unionization; this tells me that conservatives should care a lot about.  So why don’t they? One reason may be that they believe licensing increases quality. As I wrote yesterday, in my post on why liberals should care about occupational licensing, the evidence suggests this is not the case. But I don’t think this fact is generally appreciated.

One explanation is that, in contrast to unionism, licensing typically requires workers to jump through some impressive, expensive, and time consuming hoops, which certainly makes it seem like it should increase service quality. Also, one can certainly imagine that for many occupations there is some theoretically optimal non-zero level of licensing, but that public choice problems –highlighted here by Matt Yglesias– make that impossible.

Many conservatives may not grasp the public choice problem, and instead have too much trust in the institutions that set licensing standards. But these are mandatory government institutions, which conservatives should be skeptical of and instead favor free market, optional ones. At the very least they should favor mandatory testing, registration, and certification which allows people to work in an occupation even if they fail, but without the “Government Certified” stamp of approval.

Dean Baker’s hypothesis is that conservatives, journalists, and other professionals not complaining about occupational licensing is about class; specifically, the professional class. He argues that “free traders” only want free trade in low-skilled labor, and not high-skilled labor like doctors and other professionals. This is why they don’t complain when trade agreements come with restrictions on professional labor markets, like those on foreign doctors, but they do complain when they come with restrictions on low-skilled labor.

Even more puzzling, he argues, is that  people are more concerned about restrictions on low-skilled trade between countries than on high-skilled trade between states:

The “free-trade” crew want to have a single set of standards for all forms of merchandise traded all over the world, but it has apparently escaped their attention that a lawyer from New York can’t practice across the river in New Jersey.

I don’t necessarily believe Dean’s diagnosis that free-traders really want is “cheap nannies”, and that their motivations are selfish. For one thing he frequently charges journalists with this, but are governmental barriers even among the top 10 things stopping a significant number of immigrants from putting journalists out of jobs?  I do think that there is some sort of professionalism bias occurring, but it’s a bias towards believing that high-skilled labor market restrictions are for everyone’s benefit, not just their own.

In any case, whatever their motivations I think conservatives should care more about occupational licensing because it prevents free trade between the states, increases protectionism in professional services, and is a labor market restriction that is as expensive as and more pervasive than unions.

My final comment in this two-part post on occupational licensing is that I would like to see the ideologically diverse individuals and institutions who oppose occupational licensing to work together on this issue. This could be co-sponsoring papers, panels, or entire research programs. Dean Baker at the liberal CEPR, many at the libertarian Reason Foundation, and Matt Yglesias at the liberal Center for American Progress are on the same side and have written passionately about this issue. So why not a CEPR, CAP, Reason joint research program on occupational licensing? Just give me a call when you start handing out research grants.

When James Pethokoukis said he heard tale of a Fannie / Freddie surprise before the mid-terms I assumed it would be something along the lines of this plan Bill Gross is putting forward.

Bill Gross, who runs Pacific Investment Management Co.’s $239 billion Total Return Fund, said that policymakers “should quickly re-engineer” a plan that would refinance all non-delinquent mortgages backed by the federal government. The rate on a 30-year fixed-rate mortgage averaged a record-low 4.44 percent in the week ending Aug. 12, according to taxpayer-owned mortgage giant Freddie Mac

Not loan forgiveness as Pethoukis suggests

Indeed, if the US government would announce that Fannie and Freddie have full faith and credit then we could probably refi everyone in the United States at around 3.5 – 4%.

Its hard for me to see how  fully secured Fannie / Freddie debt could trade at a higher  yield than 30 yr Treasuries. The prepay risk is basically inverted. Yields can’t go much lower, giving the homeowner little option value.

However, some people will move, default, etc. Which means you get principle back on average much earlier than 30 yrs.That would tell me we should trade at or near the 10 yr bond yield.

Hard to say because you have to figure that if people can refi at 3.5% those people aren’t going anywhere unless they absolutely have to, so the average duration is going up. Still with 10 yrs trading at 2.6%, 4% seem eminently doable even with the massive increase in high-quality supply

UPDATE: For those with a little more bond experience. If I hold securitized Fannie / Freddie debt and a borrower defaults do  I get principle or does Fannie / Freddie make the scheduled payments? I assumed the former but thinking about it more I am not sure.

Siegel and Schwartz argue that there is a bubble in the bond market. Brad Delong is baffled.

I’m not sure if I go quite as far as Brad does. Bonds can be in a bubble if people are mispricing default risk. Indeed, CDOs, which are at the end of the day fixed-income products, were in a heck of a bubble a few years back.

However, is that what’s going on here? A sudden increase confidence in the US? Perhaps, it was Peter Orszag’s latest budget? Or, maybe bondholders are convinced that Democrats will let the Bush tax cuts expire thereby ending any chance of future deficits? Got to get your hands on that government debt before they stop printing it, eh?

Somehow I doubt it any of this.

No, this looks like a good ‘ole fashioned flight to quality. Nothing is certain in life but death and taxes and US Treasuries are backed by the most powerful taxing authority in the world.

But, you’ve heard enough from me on this, I’ll hand the mike to Milton Friedman circa 1998


Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

Japan’s recent experience of three years of near zero economic growth is an eerie, if less dramatic, replay of the great contraction in the United States. The Fed permitted the quantity of money to decline by one-third from 1929 to 1933, just as the Bank of Japan permitted monetary growth to be low or negative in recent years. The monetary collapse was far greater in the United States than in Japan, which is why the economic collapse was far more severe. The United States revived when monetary growth resumed, as Japan will.

The 4% Club is still accepting nominations


These are the first slides of my class PUBA 732: Economics for Public Administrators

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Via Ryan Avent, Narayana Kocherlakota explains why he won’t be applying for membership in The 4% Club anytime soon.

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.

I am, of course, open to Kocherlakota’s argument. However, the data series he argues from is extremely young and I have strong priors here. Moreover, this is exactly the type of grumbling that we heard out of the Bank of Japan during the 90s: Don’t blame us there are deeper, structural, problems out there.

I am always doubtful. Geography matters, no doubt. People have ties to families and friends, and in the current environment walking away from an underwater home is not without costs. However, the idea that the economy needs certain kinds of workers but only has certain others strikes me as balderdash.

For one thing I haven’t seen a lot of hard data about excess demand in any part of the labor market. Education and Health are still growing but not at a rate faster than before. Perhaps, nursing salaries are being bid up fast enough to clamp down on quantity demanded but I would have to see a lot of evidence here.

Second, this whole idea just seems cockamamie to me. People can do different things. Its not like, once a welder always a welder. They may have to accept lower pay and they may be reluctant but if any market has the pressure to make people think about changing careers then this it.

FRED Graph

On the other hand you might says its just skills. What we need are more biotech engineers but that takes time and training. However, that has it all wrong. The market doesn’t need. There may be high demand for biotech engineers, though again from what I can tell our young science graduates are terrified of the market place. However,  a shortage of engineers will bid up the price which in turn will increase the demand for substitutes.

In addition, it will make those engineers more wealthy and more likely to spend on personal services. For example, I went to a premium grocer here in West Raleigh last night. This area is a creative class Mecca, topping out all of Richard Florida’s charts. We have biotech, infotech, back-office financial services, stats, you name it.

We also have grocery stores where there might be as many employees as customers. Its a place where food can be custom prepared for you, from fresh ingredients. Its a place where the baker will call you when he is putting in a batch of your favorite cookies so that you can get them fresh out of the oven. Its also a place where “groceries” cost more than causal dining. Its a place that was created for the creative class.

It does not, however, employ the creative class. It employs people who in another time, in another place, would have been factory workers or diner waitresses or any other stereotype of forlorn middle America.

This is how markets work. They shift people and resources towards their most highly demanded use. If that’s not happening then the market is not working. The most obvious cause of sudden, massive market failure is the general glut or excess demand in the market for money.

So, again I am willing to hear the structuralists out. However, extraordinary claims require extraordinary evidence. The idea that markets are functioning smoothly but we just can’t think of a way to profitably employ the 14.5 million Americas who say they are looking for a job but can’t find one, is extraordinary.

Did you know that you can’t tell the future in Maryland? I’m not saying that you are physically (or psychically) unable to peer into the future and divine important information for residents of the Chesapeake Bay State, but that you are legally forbidden from doing it unless you have obtained a license to do so. Most licensing is not as frivolous as the fortune-teller example, yet as Karl recently argued, many commentators who are otherwise concerned with bad government policy tend to ignore it. This appears to be a problem with both the left and the right, so I want to offer arguments for both liberals and conservatives that occupational licensing is worse than they thought. Today I will attempt the harder case of persuading liberals, tomorrow conservatives.

I think the liberal tendency tend to ignore or even outright support occupational licensing comes from two motivating beliefs: they envision it as a way to generate upward mobility and create middle class jobs, and they believe it to be effective way to prevent people -especially poor people- from being ripped off, injured, or otherwise done harm.

The appeal of licensing as a way to create better jobs is obvious. Making it harder to do a job certainly restricts supply, and so as you would expect the evidence has shown licensing increases wages. The evidence shows that, while the impact varies by occupation, the average increase in wages from licensing is 10% to 15%. So if licensing helps barbers get a 15% increase in his wages, then that can appear to be a desirable wage subsidy.

The first problem with this is that every occupational license that affects wages does so by limiting supply. This means that for every increase in hairstylist wages from licensing, there are would-be hairstylists thwarted and pushed into a lower paying job. In his book “Licensing Occupations: Ensuring Quality or Restricting Competition?”, Morris Kleiner uses state-by-state variations in licensing to show that employment growth for a given occupation is 20% higher in states where they aren’t licensed.

Furthermore, given that 73% of licensed workers have a college degree, and 44% have more than a bachelors, these higher wages will frequently come from the pockets of individuals with lower-income than those who benefit. Studies on the impact on prices of licensing generally find effects ranging from 4% to 35%, so the amount is significant. Increasing the wages of inner city barbers may be a good thing ceteris paribus, but in reality this happens at the expense of other inner city residents.

Another problem is that occupational licensing is often a tool with which one occupation fends off competition from another, usually lower wage, occupation. For instance, many states have regulations preventing dental hygienists from practicing without the supervision of a dentist. Dentists have an average of six years more schooling than a hygienists, who on average have 2.6 years of post high-school education. In addition, dentists make on average $100 an hour, and are 80% male, whereas hygiensts are 97% female and make around $37 an hour. Kleiner and Park find that these regulations transfer $1.5 billion dollars a year from hygiensts to dentists. This is a highly regressive transfer to a male dominated, higher educated, higher paid job from a female dominated, lower educated, lower paid job. In a very similar vein with likely similar impacts, many states restrict the ability of nurses to practice without the supervision of doctors. In fact these regulations are currently growing as regulators rush to restrict the number nurses working in retail health clinics in a variety of ways to prevent them from competing with doctors.

Considering all of the above ways in which licensing tends to benefit relatively higher wage individuals who on average have a college degree or more, it strongly suggests the impact of licensing is regressive.

The second motivation of liberals in supporting occupational licensing is that they see it as an important regulatory tool with which to protect consumers. I think part of the problem is that liberals tend to envision the debate in terms of the most extreme examples. The number one response I get from liberals when I criticize occupational licensing whatsoever is to say “what, and you think anyone off the street should be allowed to do brain surgery? Typical libertarian extremism”. But this is framing the issue wrong in two ways.

First, it is wrong to assume that in the absence of licensing occupations, these jobs would be practiced by Joe Schmoe off the street. College professors, for instance, generally do not face licensing requirements, and yet we don’t suffer from a scourge of colleges hiring high school dropouts to teach physics.

Second, the options are not just occupational licensing or absolute laissez faire. It’s best to think of licensing as existing on a spectrum of occupational restrictions that range from very heavy, like the government defining who, what, and how very specifically, to exceedingly light, like optional registration. Liberals can support moving down this ladder without believing we need to get off it entirely.

For instance, instead of occupational licenses, governments could mandate testing, and offer certification for those who pass and have some set of qualifications. They could also allow private groups to offer alternative, competing certifications. Consider how much we have benefitted from the alternative certification process of Teach for America. In addition, there are variety of ways to have less restrictive occupational licensing, which the differences between states shows. After all, the empirical literature on this topic can exist because states vary greatly in the extent of licensing. Indiana has around 11% of it’s workforce licensed, while California has 30%. If all states moved towards regulatings more like Indiana it would be an improvement without requiring any sort of radical libertarian experiment.

Another problem with occupational licensing as a regulatory tool is that there is a lot of evidence that it does nothing to increase quality. One strain of research shows that malpractice insurance premiums aren’t lower in states with occupational licensing, which you would expect if licensing was increasing service quality. Other evidence comes from research into the effectiveness of nurses in providing primary care services, which has shown they do no worse than doctors. Still other research shows that licensing and certification for teachers does not increase outcomes. While the set of occupations which are licensed is broad, and the evidence for many jobs limited, the balance of the literature on licensing suggests it does not increases quality. Part of this is probably because, as discussed above, in areas where there is no licensing other mechanisms arise or be mandated to ensure quality can be monitored.

Not only does it licensing increase quality of services performed, but for many individuals it may price them out of the legal market and into black markets or performing the services themselves. This means people doing their own plumbing or, like Matt Yglesias, giving themselves haircuts, because licensing pushes prices higher than consumers are willing to pay. Potentially worse, low-income individuals may simply forego these services, causing more damage in the long-run… well, not for haircuts.

A great example this comes from underground dentists who operate in dirty basements using unclean equipment. Here is a description of what this looks like in New Jersey:

They set up their shingles in dingy basements, garages and spare rooms in apartment buildings across New Jersey.

The equipment includes seating ripped out of cars, rusty tools to probe inside mouths and soda bottles to dispose of spittle…

In Union City last summer, Luis Eduardo Gallo-Enriquez walked into a small office one floor below the waiting room of a licensed dentist, looking sweaty in muddied jeans, according to one of his patients. Gallo-Enriquez, a 45-year-old Ecuadorean native, was more than an hour late for an appointment but proceeded to charge the 25-year-old Secaucus woman $600 to apply her braces — using rusty tools and no X-rays or dental impressions — and put her on a monthly payment plan.

When she contacted him about a problem she was having with a chafing wire, he told her he had set off on a Caribbean vacation and advised her to trim the wire herself with a nail clipper, assuring her, “I tell this to people all the time,” she recounted.

Operations like this would be drummed out of business by other low-cost models if licensing were weakened. Think dentists in Walmart. Forcing transactions into the black market also prevents the other quality improving institutions, like credentialing, malpractice, and independent review organizations, from functioning. Word of mouth doesn’t even work as well when a service is illegal.

One last cost of licensing that will bother liberals is that by being issued at state, county, and even city levels, it decreases geographic mobility. A barber licensed in one county may have to jump through all sorts of hoops to practice in another, which will increase their cost of moving.

Overall I think that occupational licensing is something that liberals should care about, and that reducing it would particularly benefit low-income individuals. If more liberals were involved in criticizing licensing then the conversation would not so often end up with libertarians arguing for more extreme reforms like the removal of all legal requirements for doctors, and instead would focus on more pragmatic solutions like figuring out how we can all be more like states like Indiana, and how to encourage alternative credentialing institutions that allow more flexibility.

J.D. Foster of the The Corner warns that if America doesn’t stop its big government ways there will be hell to pay.

More spending, more regulations, more rules, and, soon, the Obama tax hikes all contribute to a loss of individual freedoms and, collectively, to an economy bearing a much closer resemblance to floundering Japan than rising China.

This is a prime example of conflating largely microeconomic issues like taxes and regulation with macroeconomic effects. I’m going to ignore the obvious issues surrounding China’s growth and the still enormous role the state plays in the economy. Instead, I am going to throw up this cluttered but informative graph

Ok, see the thick red line. That’s the United States. There is a dark blue line that’s just below the US in the year 2000, that’s Japan. Indeed, in 2005 the two lines converge as the Bush tax cuts took us down to about the level of taxes as a percentage of GDP as Japan.

You can see going back to the 1970s that the two lines crisscross. We’ve had roughly the same share of revenue taken by the government as Japan. They were a little higher than us in the 80s and a little lower in the 90s.

What’s the lesson? That slightly higher taxes during the 90s lead to prosperity in the US and slightly lower taxes in Japan to ruination? I doubt it.

On the other hand here is inflation and GDP in Japan during the 90s

Here is US over the same period


The collapse towards deflation in Japan was concurrent with the collapse of the economy. On the other hand, the stabilization on inflation in the US was concurrent with robust economic growth. Correlation is, of course, not causation and this set of graphs is not  a substitute for a complete monetary argument.

However, I hope it at least shows how much stronger the relationship is between monetary variables, like inflation, and growth, than between growth and supply-side tax policy.

This is not to say that taxes aren’t important. Its certainly not to say that regulation is not important. Its just that they have a different kind of importance than monetary policy. We are not going to revolutionize the United States by moving taxes as a fraction of GDP by a few percentage points. We could, however, crush the US economy for a decade or more by pursuing a contractionary monetary policy.

When we think about taxes and regulation we should think about them in terms of how they affect the lives of everyday citizens. Will it make harder or easier for them to achieve their goals? Will it make harder or easier for them to raise a family? And, we should think about them that way because we care whether it is easy for our citizens to reach their goals or raise a family. We shouldn’t think about them as if our decisions are likely to alter the growth trajectory of the United States of America.

On the other hand, when we think about monetary policy we should realize that we are explicitly choosing whether the US economy will grow or contract. Even economists tend to think of monetary effects as short lived, but bad monetary policy year-after-year can produce major macroeconomic effects year-after-year.

The post-housing-bubble narrative has been that the unsustainability of prices was obvious ex ante, and so we should be able to call them in the future. This to me seems to be a bit of hindsight bias, but it is always difficult to make a case that claims which turn out to be ex post false were nevertheless ex ante reasonable. Kristopher Gerardi, Christopher Foote, and Paul Willen have a new paper out that I’ve been waiting for someone to write. They go through pre-collapse claims of the housing pessimists, optimists, and agnostics, and evaluate not just who was write and wrong but which beliefs where obviously right and which were debatable. This is a fun and accessible paper starring a well-known cast of characters, with prominent roles for Paul Krugman, Dean Baker, and Robert Shiller, and a quick cameo by The Economist, Calculated Risk, and John Cassidy. I strongly recommend it.

Rereading the cases of the optimists and the agnostics should be a reminder to those who claim to have identified the bubble, and also argue for the identifiability of future bubbles, with a high degree of confidence. The burden of proof on those making those claims is to argue convincingly against, for instance, Himmelberg, Mayer, and Sinai who argue that you can’t just look at price to rent ratios, but must consider changes in the user-cost of housing.

Even more prominent than the housing optimists are the housing agnostics. Rosen and Haines argued that the academic consensus on the issue was that the relationship between prices and fundamentals was sound, and that overpriced markets, if they existed at all, were limited.  The authors find that the beliefs of agnostics can be summarized in this quotation from Davis, Lenhart, and Martin:

If the rent-price ratio were to rise from its level at the end of 2006 up to about its historical average value of 5 percent by mid-2012, house prices might fall by 3 percent per year, depending on rent growth over the period.

There is a tendency to call anyone who bought a home during the late stages of the bubble “irrational”, because prices were obviously unsustainable. But as the authors point out, the consensus of economists gave no indication that this was the case, and so behaving as if it wasn’t was quite reasonable for non-experts. Of course, pointing out that current prices were justified by fundamentals does not rationalize a 120% LTV negative amortization mortgage.

To those who simply point to lower lending standards as sufficient proof for a bubble, the authors offer this:

Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time. For our part, we simply point out that an in-depth study of lending standards would have been of little help to an economist trying to learn whether the early-to-mid 2000s increase in house prices was sustainable. If one economist argued that lax standards were fueling an unsustainable surge in house prices, another could have responded that reducing credit constraints generally brings asset prices closer to fundamental values, not farther away.

I believe the case for humility about the obviousness and knowability of bubbles is underappreciated. Many, I’m sure, will simply point to the pre-bubble agnostic consensus of economists as more evidence that economists are rational expectations obsessed, over-mathematized fools who don’t know what they’re doing. I think they would benefit from a close reading of this paper.

In shameless imitation of Greg Mankiw’s Pigou Club I announce the creation of the 4% Club, hereafter defined as:

An elite group of economists, pundits, and politicians with the good sense to advocate that the Federal Reserve adopt an explicit inflation target above the 2% level.

In an effort to create a big tent, those advocating targets other than 4% are eligible for consideration as well as general proponents of quantitative easing:

Paul Krugman

Oliver Blanchard

Martin Wolf

Greg Mankiw

Nominations are open in the comments

Note: I am no longer regularly checking the comments but I am adding new names as I discover them. I hope this list can serve as a resource for journalist or policy folks looking for a sampling of the arguments for moderately high inflation. Such arguments are of course a staple of this blog as well.

Rolling Update:

Newly Inducted Members

Kevin Drum

Ken Houghton of AngryBear

Mark Thoma

Tom Gallagher Probationary Status

Scott Sumner

Ken Rogoff

Andy Harless

Ryan Avent of Free Exchange

Tim Fernholz

Mike Konczal

Tyler Cowen

James Suroweiki

Neil Irwin

Adam Posen

Tyler Cowen takes on free parking in the NYT

IN our society, cars receive considerable attention and study . . .  But we haven’t devoted nearly enough thought to how cars are usually deployed — namely, by sitting in parking spaces.

Is this a serious economic issue? In fact, it’s a classic tale of how subsidies, use restrictions, and price controls can steer an economy in wrong directions.

Now, free parking is a favorite bugaboo of a certain strain of microeconomists and economically minded commentators. Nonetheless, little has been done about it. Equally little attention is paid to smaller and even more ubiquitous constraints on free exchange. For example, in most jurisdictions cutting hair at home can legally be done with a vacuum cleaner but cutting it for pay requires schooling, examination and a licensing fee.

On the other hand barrels of ink and the fates of political parties are determined over debates about the taxation of labor. Its a generally accepted principle of Public Economics that taxes are less damaging than regulation and in either case the broader and more uniform the restriction the less damage it does.

As such its not immediately obvious that whether we tax labor at a high marginal rate of 35% or 39.6% has larger supply side effect than whether a young entrepreneur faces a gauntlet of unnecessary classes and fees. In fact I am being too coy. I would be shocked if the taxes mattered more.

In that same vein we just went through a knockdown brawl on the expansion of health care. Yet, it would surprise me if anything short of single payer health care did as much to expand access to the poor as allowing pharmacists to sell any non-addictive drug they see fit.

If there is one part of the medical industry that clearly improves health, its the medicine part. Yet, that’s the one that we through our own choices restrict the poor’s access to the most. We restrict which drugs can be sold, we restrict who can do the selling and restrict who can authorize the sale. Surely, two levels of restriction is enough.

We don’t seem to feel doctors can be trusted to know whether or not a medicine should be prescribed at all, hence the need for the FDA. We don’t think that merely having a prescription in hand is enough to ensure that consumers will get the right drug or that they will be aware of side effects and interactions, hence the requirement for licensed pharmacists.

Yet even still, we require a third level of verification to ensure that consumers, in their apparently infinite foolishness, do not try to buy a drug they don’t need. I am not suggesting that their aren’t many cases in which a consumer might want the advice of a medical professional. However, many trips to the physician aren’t for advice, they are for permission.

These trips, these fees, these wait times are endured not because people want to know what is wrong, but because they want to be allowed to do something about it. Moreover, its precisely here that the shoe pinches for many lower income Americans.

Despite the massive regulatory apparatus surrounding pharmaceuticals many older, yet still quite useful drugs can be obtained for a few dollars. Nonetheless, the sick are forced to pay in time and money for one our most scarce resources, a doctor’s time, in cases where, if given a choice, they wouldn’t even bother to get it for free.

This is the tyranny of big ideas. Reworking America’s health care system, raising or lowering taxes on millions of Americans, fighting the deficit, securing our children’s financial future, etc. These are grand ideas, complicated ideas worth the time and effort of the most serious people in America.

Letting Mary Wilson cut hair if she wants, letting Mark Sanchez buy an asthma inhaler for his kid if he wants or letting Sam Jones open a little grocery store without buying a quarter-acre of parking spots for customers who are more likely to take the bus, these are small ideas. Yet, they are ideas that could directly and immediately affect the lives of the most vulnerable Americans.

They are ideas that could go a little ways towards easing everyday pain and long way towards improving the total welfare of our society.

Here you can find the paper whose abstract contains this sentence:

“To overcome endogeneity, we draw on a quasi-natural experiment in German history and exploit the exogenous spatial distribution of baroque opera houses built as a part of rulers’ competition for prestigious cultural amenities.”

The title is “The Phantom of the Opera: Cultural Amenities, Human Capital, and Regional Economic Growth”.

Adam asks,

what problems do you think are important today that you didn’t think were important in 2004, and what policies would you favor now that you would have opposed then?

For me the answer is obvious, my once unwavering devotion to an independent Federal Reserve has been shattered. If in 2004 someone had suggested that the Federal Reserve should be more accountable to elected officials then at best I would have smiled and humored them. At worst I would have accused them of democratic fundamentalism and weakness-of-will in the face of our society’s ubiquitous pro-democracy propaganda.

Transparency? Oh, no, no, no, I would have said, Greenspan spoke well, when he quipped

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said

Giving clear answers only encourages a sense of ease and simplicity, which in turn encourages unexamined input. If people wish to understand monetary policy then A Monetary History of the United States is available at most libraries and every major university subscribes to the Journal of Monetary Economics.

The Great Moderation, I felt, was our greatest triumph and it was achieved only by unshackling financial technocrats from their political masters. I cheered Bob Lucas’ 2003 address to the American Economic Association declaring

[Macroeconomics originally] referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster.

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

Today, I am banging the table asking why Bernanke won’t explain the Fed’s unwillingness to adopt a 4% inflation target. Today I cannot help but wonder whether the Regional Fed presidents aren’t too far removed from the everyday pain of high unemployment. Do they not know policy failure when they see it?

The extent of my current heresy cannot be overestimated. To my former self the idea that the unwashed masses – a term that would have included members of Congress, notable media pundits and CEOs of major corporations -  had anything useful to contribute to monetary policy was as sensible as saying we should set the Federal Funds rate based on an examination of the entrails of a chicken.

Nor, do I think this was or is even today a minority position. What set Kartik Athreya apart was not his opinions but his willingness to share them with society.

I have gone thoroughly native. But, then again, facts have changed


It is a common and poor framing of the question to ask whether uncertainty is causing our current economic woes. Just as the path of GDP is more volatile and difficult to forecast than in stable growth years, the path of individual firm sales is similarly more volatile and uncertain. More uncertainty will make households and businesses save more and invest and spend less. There is nothing controversial here. The debate is about the cause of uncertainty, and here I see a troubling correlation between what people think the current villain is and what their non-recession bugaboos are. The narratives struggling to tie the current economic woes to long-run stagnating wages, an undereducated workforce, and anything Democrats do strike me as a tenuous stretch and reflect our tendency to need a compelling narrative when easy explanations do not present themselves.

I think a good test for yourself is to ask “what problems do you think are important today that you didn’t think were important in 2004, and what policies would you favor now that you would have opposed then?”. My answer is that low house prices are a problem today where I would previously said low prices are just transfers from sellers to buyers, and I would favor policies that prop them up when I would previously have opposed them. What are yours?

In response to Tyler Cowen’s semi-praise for job saving programs, Arnold Kling has this wisdom for us:

On the larger point, keep in mind that in an ordinary non-recession month 4 million jobs are destroyed and about 4.2 million jobs are created. Suppose that in a bad month of a recession, 4.0 million jobs are created and 4.5 million jobs are destroyed. Which of those 4.5 million jobs ought to be saved, because they might come back in a stronger economy? No one in Washington knows.

So in my last post I brought up Hitler, which reminded me of Godwin’s Law.

As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1

Now this, which Godwin’s original version, isn’t as bad as most formulations of the law which go something like this

If an internet thread goes on long enough someone will eventually bring up Hitler

I highlighted enough because that makes the typical formulation into a tautology. How long is long enough? Well as long as it takes for someone to bring up Hitler.

So, what you are saying is that if we wait long enough for someone to bring up Hitler then someone will bring up Hitler? Revolutionary insight.

Godwin’s a pretty smart guy so it turns out he was clever enough to avoid the tautology. But, his formulation is only ever so slightly better.


Well, depending on the constraints you want to place on the evolution of the universe  – and I will admit there are some that are meaningfully binding – the probability of anything happening approaches one as time goes forward.

This is because at any time there is some positive probability of a realization of any set of feasible set of quantum states. We know mentioning Hitler is feasible and so eventually even if just by pure deep random chance it will happen.

Indeed, in some branch of the multiverse it will happen with probability one.

What we want to say is that there exists some duration of time T, such that the probability of observing a mention of Hitler goes to one as the duration of the discussion goes to T.

Now, is there any point to this rant? No, none whatsoever. But I have been pissed about this sort of thing ever since I heard Arthur C. Clarke’s much quoted tautology on technology and magic.

Any sufficiently advanced technology is indistinguishable from magic

And, in some branch of the multiverse I was bound to bitch about it with probability one. Consider yourselves lucky or victims of inevitability, as the case may be.

Jennifer Pollom has a long piece up at Economics 21, which argues that long term spending, not taxes are the problem. By my reading Pollom makes three big points

  • Revenues, even after accounting for the Bush tax cuts, are not that far out of line with historical norms.
  • Spending on the other hand is growing like gangbusters
  • The core of the spending problem is Health Care

Pollum also makes some important comparisons, noting for example that tackling spending growth without touching entitlements would require either scrapping the military or scrapping the entire rest of the government. In fact, even the latter wouldn’t completely do the trick.

Here core argument is essentially correct but there are some important caveats to be made.

First, Pollum, like just about everyone else, leans heavily on this set of graphs.

Revenues and Primary Spending, by Category, Under CBO’s Long-Term Budget Scenarios Through 2080

You see that last date over there in the right-hand corner. If you squint you can make it out. It says 2080. That’s 70 years from now. I know what you are thinking. However, I have to keep making this point: a whole lot can happen in 70 years.

Seventy years ago Hitler had just starting bombing British factories, but the America First Committee was determined to ensure Roosevelt kept his pledge to keep us out of war.  They had good reason to be hopeful, after all public support was with them.


A year later that hadn’t turned out as expected. The next 70 years held a lot of surprises as well. The birth of the modern welfare state, the baby boom, Women’s Lib, the Civil Rights movement, the rise and fall of communism as a geopolitical force. I could go on.

The point is American life and Americans’ relationship to their government changed in ways that experts in the 1940s could not have imagined. It is hubris beyond all measure to think that these projections are even a semi-precise portrayal of what is going to happen. We have to always keep that in mind.

Second, this whole Health Care thing. It’s really a ball of knots. However, there are a few things we just have to keep straight.

To start with, the spending issue on health care isn’t a government issue. Its a national issue. Its really a global issue, but we don’t need to go there. The whole country, public and private is being squeezed by the rising cost of health care.

Now you might say, yes but if people were given responsibility for their own health care expenditures they would make more rational choices. The problem is, people have never had responsibility for their own health care expenditures and there is little reason to think that they ever will.

One reason is obvious. The people who are in most dire need of health care aren’t in any condition to be responsible for anything. That’s why they need health care. Second, their loved ones typically aren’t in the most rational state of mind either. In fact, Robin Hanson makes a fair argument that the entire notion of health care is rooted in emotion and fear.

However, even beyond that health care has always been mostly paid for by someone else. Even before the government got into the business of explicitly buying most of the health care in the United States,  health care was actually paid for by insurance companies.  In fact, it is from the study of insurance companies that the notion of moral hazard arose.  The problem people noticed was that when people were spending the insurance company’s money they tended not to be so careful about what they bought. Rascals, I know.

That’s basically the same problem that we have with government. The fact that you have a private entity creating moral hazard doesn’t do much to change its fundamental properties.

We could go back even further, before the rise of medical insurance, and we’d see that most health care was bought either by the local governments, the military or the church. Again, most people were insulated from the cost.

Now, we could say that Health Savings Accounts will solve all that, and in truth they’re not a bad idea. However, they’re not really a solution either. Half of all health care dollars are spent by the sickest 5%; people who would blow right through their HSA caps. The bottom 50%, that’s most of us, account for less than 3% of all spending.

So what’s my takeaway? Its that whether the government buys health care or whether the private market buys health care is not likely to change the fundamental dynamics. Most people don’t make their own fee-for-service decisions, they never have, and they probably never will.

However, there is a bright side, which is this: something that can’t go on forever, will stop. I stole that little gem from Ben Stein’s dad, in case you didn’t know. In relation to health care what that means is that I don’t expect excess cost growth, that is health care cost growing faster than the economy, to go on forever.

Literally, it can’t go on forever. Eventually health care will be the economy and then the two numbers by definition have to match. However, even before we get to that point someone is likely to balk. What we would love to see is a bunch of rational agents, each calmly and carefully deciding exactly how much of their income they are willing to fork over. But, like I said above, that ain’t gonna happen.

What we will see is a national freak-out. One in which all sorts of caps and legal constraints are placed on the growth of health care costs. If we someday have a single payer system this will be done quietly behind the scenes as is now happening in Canada. If we still have a mutli-payer system then its going to be a political firestorm but the end result is going to be the same. Artificial constraints will be placed on the growth of health care costs.

What that means for that big CBO graph is that health care costs are almost certainly not going to keep rising at the same rate for the next 70 years. Something is going to stop them.

So what’s left to be done. Am I saying that we just put Alfred E. Neuman at the helm and forget about it?


There are some important choices to be made. For example, when the clampdown comes we want it to come in such a way that minimizes inefficiency and leaves open the potential for some technological advances to continue. This will not be an easy task, as our most potent tool, the decentralized free market, is not available. However, it is an important task and one that we should begin thinking about.

Oh, and I lied. Turns out I’m a rascal as well. There is a lot more to read on spending, taxes and health care. We haven’t even talked about taxes for example. But, I had to get you through this monstrosity of a post somehow. I couldn’t very well depend on your rational informed consent could I?

Economists often caution that in a global recession everyone can’t growth at the expense of their trading partners, either via currency devaluation, protectionism, or other policies designed to stimulate domestic demand at the expense of imports. If countries try such “beggar thy neighbor policies”, it will just make everyone worse off, since everyone is weak and everyone will defend their growth with similar measures. But what if everyone wasn’t weak. What if there was some healthy neighbor country whose growth we could siphon and feed off like a vampire. If there was such a neighbor, perhaps we should beggar them…

On an unrelated note, lets talk about Canada. Here a graph showing the healthy state of their housing market.

Nothing too volatile going on there over the last decade. Slow, steady, dependable, unexciting growth: that’s Canada. They’ve almost completely rebounded from the minor fall in prices.

Here’s a couple more facts on Canada’s performance relative to the rest of the G-7 from this report :

  • Canada’s GDP declined the least during the recession
  • Canada is the only country to have almost entirely recovered their full output decline
  • Canada’s job losses, which only occurred for 3 quarters, have been fully recouped
  • Canada is the only one to have year-on-year GDP growth from March 2010
  • The IMF and the OECD expect Canada to grow the fastest over the next two years

Here’s what their GDP growth looks like:

Looking pretty healthy there. They grew 6.1% in Q1 2010, their fastest rate in a decade. Surely that’s more economic growth than any one country needs all for themselves.

Not only are they growing faster, by some measures they’ve got more economic freedom than us now. All I’m saying is that’s a real nice economy they’ve got there; I wonder if, maybe, we could just borrow a little bit of it. We can do this the easy way or the hard way. The easy way would be Canada upping their U.S. imports and tamping down their exports.

The hard way? Well I’m not sure what that would be. But Canada has definitely been home to a some terrorists, heck you might even call them a “haven for terrorist activities”. I hear Paul Bremer’s not too busy these days, and CPA could just as easily stand for Canadian Provisional Authority.

Liberal bloggers have cited the work of John Schmitt at CEPR and Bender and Heywood as showing that, despite conservative complaints, state and local public sector workers are actually underpaid compared to private sector workers. I have disputed those results elsewhere, but I’ll let that fight go for today. What I want to look at is whether federal employees are paid more than private sector workers.

Using the same data from those studies that Krugman and Cohn cite favorably (CPS ORG), and the filters and variables from Bender and Heywood*, I’ve taken a look a public sector pay for federal employees. As a first pass I found that federal workers are paid 18.2% more than private sector workers. This includes controls for age, gender, marital status, education, state residence, race, and union coverage. Using a more conservative regression that includes occupational controls and hours worked it comes to 17.8%.

So there’s probably some systematic differences between federal workers and private sector workers that we’d want to account for. One important difference is that a lot of federal employees live in Washington D.C., which I assume has a higher than average standard of living than average. To control for this I re-run the regressions dropping out all workers who live in D.C., and then I tried it again dropping everyone in Virginia as well. Still around 17%.

Maybe federal employees are more concentrated in cities, again with higher cost of living. To control for this I dropped all workers living in a Combined Metropolitan Statistical Area.  Federal employee pay premium goes up to 24.2%. Dropping D.C., V.A., and MSAs gives you around the same.

Just for kicks, if you run it without controlling for union coverage, as I’ve argued you should, the wage premium is 31.8% if you use the geographic restrictions above, and 24.3% if you don’t. In contrast to state and local public sector wage premiums, which I found were concentrated primarily in low education workers with wage discounts for more educated workers, excluding these regressions to workers with college and post college only still has a wage premium of 16.2%.

A note for skeptics: If there’s other controls you would like to see included I’m happy to throw them in and re-run the regressions. There’s no need to call me a hack because I didn’t control for bananas per capita or something, just convince me in the comments that I should and we’ll see what happens. It may be that controlling for some factor I haven’t considered will make these results go away. I’ll grant that it’s certainly possible.

But until then… No matter how I cut it, using the same data and methodology that Paul Krugman and others have stood behind as proving local and state public sector workers were underpaid by around 5% shows that federal workers are overpaid by over 15%.

*I would have loved to do the analysis using Schmitt’s filters and variable definitions as well, but he hasn’t yet responded to my emails

Amid the debate over the Laffer Curve, Arpit Gupta points to a paper by Raj Chetty, et al  that suggests adjustment costs might be behind the infamous macro-micro labor supply quandary.

Here is the deal on the quandary: when we look at countries with different tax rates we see big differences in how much people work. Yet, when we look inside of a country we see very little difference in work habits when taxes change. What’s going on? Are taxes a big deal or not.

One answer, the answer I have traditionally favored, is that high tax countries also have other policies which reduce work hours. They have strong labor unions, heavy labor regulations and generous benefit packages. Perhaps, its these things that really drive down hours worked.

This new paper offers a different answer. It takes time the authors say for adjustments to work their way into the institutional structure of a nation. Companies set work hours but they do so partially in response to worker preferences and partially in response to what other firms are doing.

This implies a big coordination. First, workers have to all come to the realization that they’d really prefer working fewer hours. This in itself might take time since most people don’t pay attention to what they’re paying in taxes until April of the next year rolls around and even then it requires a bit intellectual gymnastics to realize that it suddenly became worth your while to work less.

Yet, just because each individual worker realizes this doesn’t mean that he or she is going to have the opportunity to choose a job that offers fewer hours. No, that doesn’t happen until there are so many workers wanting fewer hours that some firm realizes that it can get a competitive advantage by offering workers more flexible hours but lower pay.

Once that one firm has changed its policies other firms observe that its getting an advantage, so they change their policies. However, now there is more competition in the flexible hours space. This bids wages back up a bit, but encourages even more workers to seek flexible hours.

This process spins round and round until eventually we arrive a new equilibrium, one in which everyone is working less but getting paid roughly the same amount per hour. This is big difference between the advanced European economies and the United States. Worker productivity and hence, total per hour compensation, are roughly the same but hours worked are much different.

However, because this process takes so long to come to equilibrium and requires coordination between all workers and companies in an economy, micro-economists are likely to miss it.

This is a nice solution and they have some empirical data to back it up.

Here has always been my problem, however. Why don’t we see massive changes in labor supply as a result of economic growth. In theory, no one should really care how much they are paying in taxes. What you care about is how much you are taking home. Now, maybe some people are just pissed that the government is taking their money but lets exclude them for now.

Take home pay is affected by taxes, sure. But, its also affected by base pay, which is in turn affected by changes in productivity, which is in turn is the ultimate source of economic growth.  In fact, over time take home pay has been much more powerfully affected by changes in base pay than by changes in taxes.

This is why even as taxes have tended to go up around the world, real take home pay has gone up as well. Base pay is increasing faster than taxation. However, we don’t seem to see people working much much more than they did in the past.

Now granted this is a hard puzzle to unravel. On the one hand there are many more women working for pay now than there were 100 years ago. On the other hand there are significantly fewer men. In addition, average hours worked per worker has fallen. There are lots of different forces pulling in all different directions.

However, my first cut at the data is striking. Take this with a grain of salt because I haven’t been through the BLS methodology reports on all of these data series and can’t be absolutely sure they are picking up what I think they are picking up.

That having been said, all together the average hours worked per employable (over 16 and not locked up) civilian doesn’t show much of a secular trend since 1964, the earliest date for which I have data.

FRED Graph

In fact changes seem to be dominated by the unemployment rate. Which I have inverted on the following graph for easy comparison.

FRED Graph

That is, the average number of hours worked by Americans seems to be primarily determined by the fraction of Americans who can find a job. Think about what this means. We’ve had huge structural changes to the US since the sixties. The Kennedy, Reagan and Bush II tax cuts. The Bush I and Clinton tax increases. The decline of unions. The rise of working women. The end of Jim Crow. The entrance and the beginning of the exit of the baby boom generation from the workforce. The decline of manufacturing employment. The rise of IT. Even two major periods of war which shrank the number of civilians.

Yet, through all of that the dominant factor in the average number of hours worked per employable American was the unemployment rate.

I don’t want to turn this into another rant about the supreme importance of monetary policy. Ok, actually I would love the opportunity to do just that but I don’t have time right now and this post is long enough already. In any case, the point is this at least from this preliminary look it seems as if there are either very deep preferences or very deep structural constraints holding steady the amount of work done in this country.

Now productivity growth is a whole different story. But that will have to be another post.

Paul Krugman is making a cottage industry out of bashing Paul Ryan. In his latest post Krugman says

So what kind of guy is [Paul Ryan]? Based on his plan (and, since my article, on the dust clouds he’s been throwing up in an attempt to confuse the issue), he’s the kind of guy with whom you can’t have an honest discussion.

All I know of Paul Ryan is what I can glean from his policy proposals and the articles written on him. However, all of that tells me that Krugman has it exactly backwards.

Rumor has it that Ryan hands out copies of Atlas Shrugged to staffers. Profiles speak of his boldness and evangelical zeal. His Op-Eds warn of tipping points and the end of democratic capitalism. His policy proposals seek to disassemble the welfare state and the progressivity of taxation. There are sentences in his Roadmap about the need for some sort of security against illness and fairness in the tax code, but they read like the add-ins of political consultants. When the Roadmap says

Until recently, Americans  were known and admired everywhere for their hopeful determination to assume responsibility for the quality of their own lives; to rely on their own work and initiative; and to improve opportunities for their children to prosper in the future. But over time, Americans have been lured into viewing government – more than themselves, their families, their communities, their faith – as their main source of support; they have been drawn toward depending on the public sector for growing shares of their material and personal well-being. The trend drains individual initiative and personal responsibility. It creates an aversion to risk, sapping the entrepreneurial spirit necessary for growth, innovation, and prosperity. In turn, it subtly and gradually suffocates the creative potential for prosperity.

I hear what sounds like Ryan’s voice. Consider the following quote from Ryan on privatizing social security.

If we actually accomplish this goal of personalizing Social Security, think of what we will accomplish. Every worker, every laborer in America will not only be a laborer but a capitalist. They will be an owner of society.

This doesn’t sound to me like flimflam sauce but the words of a true believer. And, there in lies the problem. Its not that Ryan doesn’t believe what he tells us. It’s that he does.

He speaks as if government just moved out of the way, the true capitalist spirit of every American would be unleashed. A hundred John Galts and a hundred thousand Hank Reardens would rise from the earth to propel us to era of renewed prosperity and ingenuity. All we have to do is get Social Security and Medicare off our back.

The American people, he implies, will greet the dismantlers of the welfare state as liberators.

This is the fatal conceit of many would-be conservative reformers. Ambitious liberals believe that government can make men anew by tearing away the chains of poverty, ethnic oppression and lack of access to health care and education. Their conservative breatheren believe that unshackling men from taxation and the dole can likewise produce a new man, a Randian archetype who will change the world.

Reforms on both sides can make big differences at the extremes. When there is no public education, when there is apartheid, liberal reforms can be revolutionary. Likewise, when there is communist totalitarianism, economic freedom can change a society to its core. Though even in those cases reformers should be humble about the speed of adjustment.

However, for the modern western world – a world with property rights, the rule of law, and government that is competent and honest, if not ideal in efficiency and freedom from scandal – revolution is hard to come by. Men by and large are who they are.

The democratic socialism of Sweden didn’t prevent firms like Skanska, Ericsson and Ikea from dominating their industries internationally. It is unlikely that Social Security is holding back the next Silicon Valley.

Our domestic goal is not revolution. It is to seek a marginally better world. To ease pain where we can. To open up opportunities to as many people as possible.  To reduce the injustices of our judicial system, while continuing to drive down crime. To give young businessmen and young intellectuals the best shot that they can have at achieving their potential.  This is good work. It is necessary work. It is not, however, revolutionary work and that’s ok.

Humility, not honesty, is the trait I think Paul Ryan is lacking.

In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:

And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”

I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.

I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.

Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!

How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!

In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980’s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).

The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.

In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.

Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.

P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.

Ryan Avent and Jim Manzi have recently been debating whether a carbon tax will stimulate innovation, with comments from Matt Zeitlin and Megan McArdle. There is an inherent difficulty in empirically testing the effects of increasing the cost of polluting on innovation in that you want to measure the shadow price of pollution, which includes not only direct prices like the cost of gasoline, but indirect costs like non-price regulations.

One strand of the literature examines the effect of energy prices on energy efficiency in a variety of products.  A good summary can be found in this paper by Jaffe, Newell, and Stavins (JNS) for the Handbook of Environmental Economics. They cite a study which found that energy efficiency in air conditioners and gas water heaters would be 50% to 25% lower by 1993 had energy prices stayed where they were in 1973. This paper finds similar results using a dataset of product characteristics of almost every tractor (yes, tractor)  sold in the U.S. from 1920 to 1996. Of course these results could just represent the continuing adoption of existing technology rather than innovation of new ones.

JNS also cite the work of David Popp, that shines some light on the innovation vs substitution issue.  He found that patents in energy related fields increase in response to higher energy prices. Importantly, he also found that two thirds of the change in energy use in response to higher prices was a result of substitution among existing products (movement along the production frontier), and the remaining third was a result of induced innovation (movement of the production frontier). Due to the measurement error inherent in using patents as a proxy for innovation, JNS suggest this could be interpreted as lower bound for the innovation contribution. This supports Avents argument.

An important unsettled question is the extent to which these innovations will be marginal versus revolutionary. I have yet to see empirical evidence on this, and it is hard to imagine how you would in fact conduct such a study.

Mark Price has some thoughtful comments in response to my previous post on public sector unions, and I recommend those interested in the issue read them. I’m going to respond to some of his points here.

He first points again to several studies suggesting that public sector pay is not too high. As I’ve tried to show though, adding in other controls brings the public sector discount to approximately zero. Also, given that benefits and unobservable job perks are higher for public sector unionized employees the lack of a significant public sector discount suggests they may be overpaid. At the very least the studies don’t tell us that the public sector isn’t overpaid.

I’d also like to point out another way to look at the data, which is to exclude controls for union coverage. The EPI paper Mark cites does this, arguing that:

Union status was omitted from this study on earnings comparisons, since it has been a focal point of the compensation controversy. This means that, in essence, we are statistically comparing unionized public-sector workers with all private-sector workers—both union and nonunion—rather than with their union counterparts. Unionized private-sector workers have both better pay and higher benefits, of course, so our standard of comparison is very conservative.

There is certainly some sense to that. Consider this thought experiment: imagine if the majority of the 61% of public workers that weren’t unionized joined a union tomorrow, and their wages went up by the 15-20% union wage premium. Would we really want to ignore this increase in examining the pay of these workers? I would argue no.

I’ve rerun the regressions without union variable, with separate regressions for each education level to control for heterogeneity. The results, shown in the table below, indicate that there is in fact a public sector premium for lower education workers and a public sector discount for more educated workers. One explanation may be that non-wage benefits are higher for more educated workers. It could also be that the more educated accrue non-monetary benefits for public sector work, such as the prestige or valuable experience. Think financial sector regulators who go on to work at Goldman.

In any case, I don’t think the data contradict my point, and while I’m not going to hang my hat on these results, they do appear to support my argument for some segment of public sector workers.

Another point Mark argues is that the existence of a public sector union wage premium, just like there is a private sector union wage premium, is not evidence that public sector unions have too much power. So if I understand him, his criteria is that public sector unions must be able to set wages higher than private sector unions in order to have “too much power”. But as Richard Freeman says in 20 year anniversary symposium on his book “What Do Unions Do?” that Mark cites, public sector unions are so different from private sector unions that they did not cover public sector unionization in the book because they require a different analytical framework. These differences mean that simply understanding that the power and effects of private sector unions are often overstated doesn’t really shed a lot of light onto the issue of public sector unions, regardless if the relative union wage premia.

Let me give an example of one important difference. If a private sector union has too much power they may cause disemployment for that firm and industry, and at worst put the firm out of business. In contrast, a public sector union with too much power will affect the ability of the government to effectively provide public goods. The latter case has the potential to be much more harmful that the former. Education, roads, public transportation, regulation, and public health are more important than most consumer goods. I’ve spoken with many liberal economists who support private sector unions but oppose public ones for just this reason.

Mark also suggests that time series evidence is required, and that the wage premium should be increasing. I disagree with this. A falling premium is entirely consistent with a union that still has too much power, but power that is dwindling over time. Also, too much power does not necessarily mean a faster rate of wage growth, but could simply mean a higher level of growth. I think both of those statements are likely true about many public sector unions and their wages.

One issue where I want to agree with Mark is his claim that my main point was “sloppy”. That’s definitely true; I did not bother making the statement precisely. I didn’t bother because I believed (and believe), that I am making a common sense, uncontroversial claim that’s mostly about politics: public sector unions have the power to influence government.  Freedman makes the power of public sector unions clear in his chapter from the symposium:

A realistic analysis of public sector unions has to factor in their role in shifting demand for public services through lobbying legislatures or city government and through campaigns to convince citizens that they need more public services, as well as their role in shifting the allocation of budgets toward workers.

Take the NEA with it’s 3.2 million members and $350 million dollar annual budget; they’re seventh largest contributor to political campaigns over the last 20 years. Yes, I believe they have power, and I believe they block beneficial reforms, including teacher pay reforms. Maybe Mark disagrees that the political power of the NEA and public sector unions like them is a bad thing, but that is a separate issue from whether they have a whole lot of power. If our disagreement is really about whether they use their formidable power for good, than that’s something we can agree to disagree on (for now), but attacking my point by arguing about wage premiums is a roundabout way to argue that. “They have lots of power and it’s good” is different than “they don’t have lots of power”.

What impact did the Federal Reserves $1.25 trillion LSAP (large-scale asset purchase) intervention in the mortgage backed securities market have? A new Boston Fed paper investigates:

Our analysis yields three main findings. First, the announcement of the LSAP program led to significant reductions in interest rates for borrowers almost immediately…

Second, the Fed’s initial announcement led to an immediate and large increase in borrower activity in the primary loan market. The records show an increase of approximately 300 percent in the number of borrowers shopping for refinance mortgages… this increase in shopping activity translated into a 150-250 percent increase in the number of applications and subsequent originations….

Third, the initial LSAP announcement generated a significant shift in the characteristics of borrowers. In particular, refinancing activity became highly skewed toward borrowers with high credit scores.

The authors offer a variety of possible explanations for that third finding, but the huge variance of impact by borrower credit quality is shocking:

Comparing the day before the initial LSAP announcement on November 25 to the day after, we see a bit more than a doubling in the number of refinance applications that led to origination for borrowers with FICO scores below 700. For borrowers with FICO scores between 700 and 720, that number more than tripled, for those between 720 and 740, it quadrupled, for those between 740 and 760, activity quintupled, and for those above 760, activity went up more than seven-fold.

I’m coming to the party late, I know…but I figured I’d comment on the Fed’s inaction today as a result of the FOMC meeting. Here are some quotes:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period

This has, of course, been the Fed’s position since the big crash in late ’08. As I have argued, and have tried to provide reasonable evidence for; low rates for an extended period — contrary to being a sign of accommodative policy — is a sign of monetary failure. Since I’ve been fairly vocal on this point in various venues (especially on Twitter), I won’t belabor the point.

In any case, the “big policy announcement” was that the Fed is going to shift its profits from MBS sales into US Treasuries. Thus, it will freeze its balance sheet at the current levels:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature. [emphasis mine]

Fairly basic Keynesian cross analysis will tell you that this is a mostly meaningless gesture, as fluctuations in the monetary base does not have any meaningful effect on the price level while in a “liquidity trap”. Nonetheless, Paul Krugman is tepidly optimistic, noting that this merely changes the focal point of the Fed’s strategy from one of tightening to one of “holding the line”. He calls on us to keep up the pressure:

What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.

Of course, I more pessimistic. The stock market indices are flat on the news, and the 10-yr T-bond has actually steadily fallen to a current 2.79. My favorite, the TIPS spread, is at a current 1.75. That is not only well below trend, it is well below the level in which we could plausibly return to the previous trend level of output (NGDP).

This is a major problem, because it is currently en vogue to talk about “structural unemployment”, as the current length in which some people experience unemployment is reaching the fraying limits. Well, of course unemployment is going to remain high while we grind ourselves down to a new NGDP growth level. That’s going to take a long time to fully work out — if that is indeed what we are facing, and that will also necessitate much more productivity growth (and that means less humans), less investment in capital goods, and less consumption. All of those things hurt the unskilled, which are also disproportionately “the poor”.

It’s worth a look at the wrenching social dynamics which persistent deflation brings:

As long ago as 2001, Japan’s Ministry of Health, Labor and Welfare estimated that 50% of high school graduates and 30% of college graduates quit their jobs within three years of leaving school. The downside is permanently shrunken income and prospects. These trends have led to an ironic moniker for the freeter lifestyle: dame-ren (no good people). The dame-ren get by on odd jobs, low-cost living and drastically diminished expectations.


Even more extreme is hikikomori, or “acute social withdrawal,” a condition in which the young live-at-home person nearly walls himself off from the world by never leaving his room. Though acute social withdrawal in Japan affect both genders, impossibly high expectations for males from middle- and upper-middle-class families has led many sons, typically the eldest, to refuse to leave home. The trigger for this complete withdrawal from social interaction is often one or more traumatic episodes of social or academic failure. That is, the inability to meet standards of conduct and success that can no longer be met in diminished-opportunity Japan.

The unraveling of Japan’s social fabric as a result of eroding economic conditions for young people offers Americans a troubling glimpse of the high costs of long-term economic stagnation.

To end, Scott Sumner posted analysis of his reaction to the Fed meeting four days in advance (August 6th), and gave his expectation for each scenario ranging from “Very Bad” to “Inception”. Guess which end the Fed falls on…

Bad: The Fed does something minor. Perhaps it promises to maintain the monetary base at current levels by purchasing T-bonds as the more unconventional assets are gradually sold off. The Dow falls slightly. (Actually, people are now so discouraged that this might be viewed as good news.)

That is nearly literally exactly what happened.

Update: I forgot to mention, there was a single person who dissented the Fed’s decision roll over MBS into Treasuries. It is worth it to note that this person doesn’t belong on the FOMC, has no business within 5,000 yards of making monetary policy, and may not even deserve to be in banking/finance at all. Who, you might ask? Well, he was on the list last time: Thomas Hoenig.

Update 2: I just noticed that Kevin Drum did the same thing with Scott Sumner’s post. Clever guy.

Last week I wrote about falling wages in public sector unions, and suggested that due to the power of public sector unions those wages will just return to trend after the recession is over. I therefore suggested it would be better if public sector unions lost power rather than wages, since you could permanently take power but not above market wages. Via twitter labor economist Mark Price (@price_laborecon) disagreed with my claim that public sector unions have “too much” power.  If they did, he argued, it would show up in compensation data, and the evidence suggests it doesn’t. He linked to three reports (here, here, and here) that show that public sector wages are no higher than, and often lower than private sector wages.

I’ve seen the paper by Bender and Heywood, and the one from CEPR before, and the third one is a paper on public sector premiums from the Economics Policy Institute. The Bender and Heywood paper uses household survey data on income and worker characteristics from the yearly Outgoing Rotation Group in the Current Population Survey (CPS) to estimate whether there is a public sector wage premium after controlling for worker characteristics. I’m going to focus on this paper because it is the strongest and most relevant: the CEPR paper is missing important controls, and the EPI one only applies to New Jersey.

In short, the study finds that controlling for age, education, race, gender, whether they are married, state of residence, and union status, both local and state public sector employees are paid less than private sector employees. The first thing to note is that union status is controlled for, which means that public sector workers are paid less if you ignore the wage premium they get from being in a union. My claim was that public sector unions possessed too much power, so removing a wage premium attributable to union status gives you an answer that is beside the point. My claim isn’t that all public sector workers have too much power, or that public sector unions have too much power relative to private sector unions.

This study in fact supports my argument if you use Dr.Price’s metric. The regression coefficients on page 8 of the report show that the union wage premium is between 15% to 16%, while the public sector wage discount is around 11%, meaning unionized public sector employees are paid 4% to 5% wage premium. Thus the power is showing up in compensation, which is what Dr.Price suggested should be the metric for “too much power”.

There are other interesting issues here as well. I obtained the datasets from here and with the help of Dr. Bender, one of the study’s authors, I was able to recreate the results. One important point is that if you include occupation controls, and include average hours worked and hours worked squared (which you should) the union premium increases and the public sector discount drops, so that the total differential (union + public sector) grows to 18.1% for local and  15.2% for state.

Another important point is that some public sector jobs will obviously pay less than private sector jobs for reasons unrelated to unions or wage setting power. This is particularly true for more high skilled occupations. Public defenders, for instance, are going to get paid less than the average private sector lawyer. I don’t know whether this is due to lower abilities and skills or simply a willingness to accept lower pay because they want to perform a civic duty, but either way it’s pretty unrelated to the issue of public sector union power.

The heterogeneity of these results across different skill levels becomes clearer when we look only at workers with less than a college education (including those who had some college but not complete it). The union wage premium here increases to 22% for both local and state, and the (now statistically insignificant) public sector discounts are 1.2% and 1.3%. Thus lower educated workers earn around 20% more when working for a public sector union than they would if they were non-unionized public or private sector workers.

A final point I’d like to make is that a wage premium is not equal to public sector union power. A powerful union may use all of it’s bargaining power to negotiate for absolute job security, which could then select for a different set of workers with lower unobservable skills. In this case you would observe wages equal to or even below private sector wages despite a clearly powerful union. Some would argue this is exactly what teachers unions do.

[UPDATE: Regression results above slightly corrected]

With regulations set to come into affect limiting overdraft fees, the banking industry is already in the process of ending free checking. Here are some numbers that explain why:

The typical checking account costs a bank $250 to $300 a year to maintain… If the account isn’t generating at least that much in revenue, it’s a loser.

Overdrawn ATM and debit card transactions made up half of the $37 billion consumers paid last year in overdraft fees. The other half came from bounced checks and recurring electronic payments, which the new law doesn’t affect.

PNC, the bank with the greatest presence in the Cleveland market, said it expects to lose nearly $300 million a year in overdraft revenue. No. 2 KeyBank expects to lose $40 million a year.

The article also speculates that banks will respond via the following:

• Increasing fees for services such as getting a cashier’s check or money order.

• Adding fees for things that are now free, such as banking at a branch or getting a statement by mail.

• Creating electronic checking accounts, with no checks or paper to process.

• Dropping no-strings free checking accounts.

From a new NBER working paper:

…Real, constant quality land values have increased by nearly 800% since the first quarter of 2003, with half that rise occurring over the past two years. State-owned enterprises controlled by the central government have played an important role in this increase, as our analysis shows they paid 27% more than other bidders for an otherwise equivalent land parcel.

Has the entire globe been overbuilt? I can foresee a future where a global housing bubble (maybe not this one) leaves governments realizing that the only way to sop up excess housing demand that is killing economic growth is to encourage procreation and immigration. Beggar-thy-neighbor immigration policies will be the new trade wars, and blogs and social scientists will debate about how best to incentivize having children. Statist governments (and, again, bloggers and social scientists) will try to figure out whether outlawing abortion will increase or decrease the population, which in a world of rich countries with more than open borders will have to go hand-in-hand with emigration restrictions.

In a previous post I noted that a true Rawlsian wants to tax the consumption of the rich, not the income that they would otherwise be putting back into their businesses and investments.

This is important because the majority of the super-rich consume only a small fraction of their income. This implies that we are taxing away funds that would otherwise be recycled into proven business enterprises. This is important. Not all investments are created the same. In nerd speak there are heterogeneous non-reproducible inputs to production.

An income tax on the wealthy explicitly takes more from those who have shown the best skill at employing resources. This doesn’t matter for consumption, because there is no reason to value one person’s consumption over another. However, it does matter for investment because some people are clearly better entrepreneurs than others. For uber-nerds I’ll address Modigliani-Miller at the bottom.

So, what do we do instead. The goal is to have a progressive consumption tax. That is we weight the burden tax system towards the wealthy, but only in terms of consumption.

The immediate concern obviously is that because the super wealthy consume so little of their income we won’t be able to achieve the progressivity we want. But lets think about where the money has to flow.

When we tax consumption instead of income we are basically exempting savings from taxation. What happens then. Well, one thing that could happen is that the wealthy save less. That is they have a specific savings goal in mind and now its easier to reach that goal. In that case the consumption of the wealthy rises and we retrieve some of our lost progressivity.

On the other hand, the net savings of the wealthy could rise. This would mean that in the first step we are loosing some progressivity. But, what happens next?

In a healthy economy – that is outside of recession – that savings is transformed into investment. That investment then drives up the demand for labor which drives up wages. So, even though we are loosing some progressivity by only taxing income we are driving up wages for working people.

Now, not all of the returns from investment go to higher wages. Some of them go right back to the investor. However, again we ask: what will she do with them? If she saves them again we go through the same loop as before and drive up wages even further. If she consumes them then they go into the tax base and we retrieve some our progressivity.

In short, the results of reducing the tax on savings can only be parsed out to two sources. Either an increase in the total amount of investment, which will raise wages or an increase in the consumption of the saver which will then be taxed.

Now we will probably have to end up with higher tax rates in order to retain the same end level of progressivity. However, taxing consumption doesn’t create a fundamental loophole through which the wealthy can escape. One way or another it all comes back to investment or consumption.

So where do we start. A good jumping off place would be the Bradford X tax which is a progressive consumption tax. There are other approaches including combining a VAT with a wage subsidy, my preferred choice.

However, this is the direction we should all be looking to move towards. Again, not because we don’t care about the poor, but because we do. A stronger economy, with a optimally designed progressive tax system is the best way to alleviate suffering.


For Nerds:

So Modigliani-Miller says that it doesn’t matter that the most successful entrepreneurs pay the most tax because financial markets will direct capital to its most productive uses regardless. However, considerable evidence exists that the there is a significant external finance premium. That is, its cheaper to reinvest your own profits than borrow from the market. The source of this premium is assumed to be information asymmetries. And such asymmetries are likely to be most pronounced in the case of heterogeneous entrepreneurial skill, as I am discussing here.

Thus, we should expect the strongest failure of Modigliani-Miller precisely in the cases of extreme wealth accumulation. Indeed, in some sense it is the failure of MM that allows extreme wealth accumulation through an interaction effect of entrepreneurial skill with the cost of capital. That is, being good gives you excess profits, which by virtue of lower financing costs give you an even further advantage over your competitors.

Mike Konczal defends E. Warren against my criticisms. Like Mike, I spent a few years in the financial industry before descending into wonkery. Indeed, I was a consultant for a major bank on a project that was at the time called LoanSolutions. At the highest levels, however, it was sold as The Intuitive Mortgage.

The idea was that a consumer should be able to sit down with a loan officer, answer a few simple questions and find the mortgage that was right for her, all with 80% less paperwork, we would say.

One of the challenges was designing such a product in the face of a dizzying array of government regulations. In fact, Alex Pollock who Mike cites as the creator of the one-page mortgage puts it this way:

In fact, virtually everybody–bankers and borrowers, members of Congress, regulators, and commentators, anyone who has ever gotten a mortgage loan–agrees that lengthy, small-type, convoluted mortgage "disclosures," which confuse instead of clarifying, are a notable failure of the American housing finance system.

This is in spite of the good intentions of the regulations requiring them. The inability of large percentages of people to correctly interpret current mortgage disclosure forms was unambiguously demonstrated by a 2007 FTC study, although we all knew it already.

In short, a major firm wanted to provide exactly the type of products Mike is championing but found regulations a barrier to doing so. This is a problem that we can all agree needs to be solved.

However, when Warren engages in narratives like the one presented here


It doesn’t help bring everyone to the table. She flat out says

I want to be clear about this. This is not a hard issue, that we face in financial regulation right now.  This is families versus banks. Its that straight forward.

Am I not to conclude that Warren views banks as the enemy? Yes, as Mike points out she often engages in some Dr. Phil style moralizing against borrowers as well. Something that doesn’t endear her to me either. But, I think she is being clear here. On the issue of consumer finance, she is on the side on the consumer and explicitly against the banks.

She is saying the banks push hard on complexity because it helps them and hurts the consumers. She says that this happened not only at the consumer level but with derivatives as well. All in a giant effort to confuse the buyer while quietly picking his or her pocket.

Part of the reason this grates on me so deeply is that flies directly in the face of obvious evidence. Look at the big pushers of exotic mortgages: New Century, Accredited, Countrywide – they are all gone. Among the big banks Wachovia touted its Pick-a-Pay as an industry leader in innovation. Wachovia is gone.  Was going bankrupt all a part of their clever plan to confuse us with smokescreens? Or just maybe something went deeply deeply wrong.

Somewhere I still have the screen shot of the Lehman Brothers webpage where they brag about their leadership in the CDO market and the multiple trillions in structured debt they had under management. Lehman is gone.

Other causalities include Merrill Lynch, Bear Stearns and for all intents and purposes Citigroup which is now effectively owned by the US government.

This was not some giant plot by the banks to trick consumers. It was a mistake. Markets make mistakes. I am the first to admit that. I even fully recognize that healthy regulations can prevent the massive externalities that result from financial mistakes.

Such regulations, however, are something that all players can benefit from. Not to wax too Bob Wrightish here but this is classic non-zero sum. Yet, the narrative that Warren is selling is pure zero-sum. Let me repeat

This is families versus banks. Its that straight forward

No complex market failures. No need to understand the inherent interconnectedness of the financial system. Not even a seeming interest in why competition doesn’t produce the product consumers want most.

Do we really think bankers just now in the early 21st century came up with idea of pulling a fast one. I think people have known about that technique for a while. Market mechanisms, reputation, repeat transactions, etc usually work to alleviate that.

What’s going on here? Why did we have such a bad outcome on both sides? Why are these markets subject to collapse and contagion?

Is she even curious?

Or do we just want to talk about Good vs. Evil. Families vs. Banks. Us vs. Them. And, do we want to use the government to attack Them?

Congress is supposed to work for us she has said, not the bullies. The “bullies” are of course tax paying citizens of the United States, but who cares about that? No need for dispassionate justice. We know who are enemies are.

I think someone Mike admires once said

On this day, we gather because we have chosen hope over fear, unity of purpose over conflict and discord.

On this day, we come to proclaim an end to the petty grievances and false promises, the recriminations and worn-out dogmas, that for far too long have strangled our politics

Elizabeth Warren’s take reminds me of someone else

One of the reasons that I am perhaps less concerned about wealth inequality than some of my fellow economics bloggers is that this type of thing tends to happen:

A little over a year after Bill Gates and Warren Buffett began hatching a plan over dinner to persuade America’s wealthiest people to give most of their fortunes to charity, more than three-dozen individuals and families have agreed to take part, campaign organizers announced Wednesday.

In addition to Buffett and Gates — America’s two wealthiest individuals, with a combined net worth of $90 billion, according to Forbes — 38 other billionaires have signed The Giving Pledge. They include New York Mayor Michael Bloomberg, entertainment executive Barry Diller, Oracle co-founder Larry Ellison, energy tycoon T. Boone Pickens, media mogul Ted Turner, David Rockefeller, film director George Lucas and investor Ronald Perelman.

This isn’t an isolated case. Academics of all stripes should be well aware that these fine offices and laboratories we are working from were often funded by philanthropic individuals.

The reason this type of thing happens is that the desire to accumulate wealth and the desire for large quantities of consumption are not the same. Though, it is unfortunate that most of our economic models assume that the later is the only driver of the former.

Generally speaking creating enormous fortunes is a simply a side effect of what people really want to do, which is create enormous organizations. Most of these individuals had a vision about the way some activity ought to be done. In order, to make that vision a reality they created an organization to do it.

However, changing the way business is done requires an organization vastly larger than what is necessary to provide you with all the consumption that you and your heirs could desire. Hence wealth as a side effect.

Now this is not true of all, nor would I even expect most, entrepreneurs. I am guessing that the average car dealer isn’t in it to change the way people buy cars. He wants to get rich, marry a beautiful wife and leave a good sized inheritance to his kids.

But, most car dealers don’t change the way we buy cars. And, that’s precisely why their organizations stay small.  The few who do, like Autobytel founder Peter Ellis, keep fighting to build their organization, often to the bitter end.

This is why its important that we keep our eye on consumption, not income. There is no inherent social harm in someone amassing a large fortune. Nor, does it necessarily contrast with our Rawlsian sense of justice. It matters crucially what they do with that fortune.

If they spend it all on gold rims and mansions in the Hills, then by all means tax that. However, it they keep putting the profits back into the business to create bigger and better organizations, then we should let that process feed on itself, rather than slowly bleeding it.  Nor is there any particular reason why we should want to tax away income that was going to go to charity in the end.

Yes, many of the wealthy spend their money on lives of luxury while poor children attend classes in broken down schools. But, then go after the life of luxury, not the wealth.

Update: So what is to be done

This should make Arnold Kling feel excellent:

“Buy new with $1,000 down,” the advertisement says, the words resting atop a trim green clapboard house offset by a bright blue sky.


The advertisement references a program initiated by the National Council of State Housing Agencies and Fannie Mae, the taxpayer-backed, government-sponsored enterprise that buys up mortgages from lending banks.

I’m pretty sure this one program offsets the entire financial reform package.

[H/T Ezra Klein]

So this is the choice you have in the fall: the party of Gingrich and Palin at war with the Cordoba house, or the party with this economic platform:

President Obama and congressional Democrats — out of options for another quick shot of stimulus spending to revive the sluggish economy — are shifting toward a longer-term strategy that promises to tackle persistently high unemployment by engineering a renaissance in American manufacturing.

That approach … is still evolving and so far focuses primarily on raising taxes on multinational corporations that Democrats accuse of shipping jobs overseas.

The strategy also repackages policies long pursued by the White House — such as investing in clean energy, roads, bridges and broadband service — with more than two dozen legislative proposals aimed at developing a plan for promoting domestic manufacturing.

Sometimes I wish the 1950s had never happened. Democrats are like a burned out 1980s rock star trying forever to recapture the glory days of his youth using the same formula that brought him fame in the first place: acid washed jeans, tall spiky white hair, and writing the same hair metal songs. “Hey, it worked once, why not try it again and again and again forever until I die alone in a trailer in an IHOP parking lot, on a dive-bar tour in between a sad show and a sadder one?”

That’s Democrats and the 1950s.

I’d never heard this story before; it is perfect:

On January 26, 2006, [Joaquin] Phoenix was in a car accident in Hollywood on a winding canyon road that flipped over his car. The crash reportedly was caused by brake failure. Shaken and confused, Phoenix heard a tapping on his window and a voice say, “Just relax.” Unable to see the man, Phoenix replied, “I’m fine. I am relaxed.” The man replied, “No, you’re not.” At this point, Phoenix saw that the man was famed, eccentric German film director Werner Herzog. After helping Phoenix out of the wreckage, Herzog phoned in an ambulance and vanished.

Whoever wrote this Wikipedia entry has done an excellent job because Werner Herzog does not just “walk away from the scene of the accident”, he “vanishes”.

Jim Manzi says that unlike physics, social science can’t make any useful, non-obvious predications. Which is funny because I can tell you straight away what will happen to equity markets in response to major policy announcements like changes in interest rate targets and the failure of TARP to pass its first vote.

Something, that didn’t appear obvious to the Congressmen who suddenly reversed course after the biggest single day loss in Dow history. In all honesty I wasn’t sure right up until the close whether we would break the single day record, for the simple fact that I didn’t know how long they would keep the books open. The vote happened pretty late in the day. I could tell you, however, that the total drop in demand was going to be record breaking.

On the other hand, all those hard science physicists can’t tell me what’s going to happen when I let go of the handle of this little toy.

That’s because the first problem does not display Sensitive Dependence on Initial Conditions but the second one does. When economists get to build the markets from scratch like an engineer building an airplane they can give you a pretty solid sense of how its going to respond to external stimuli.

We see this in some of the complex financial exchanges that economists  have built. We see this in things like the medical match market that Al Roth built.

However, when you get stuck out in the real world things get considerably messier. Build a rocket ship to the moon, sure. The liftoff engine is really big, kinda like a 2% hike in the Fed funds rate. And, once you get high enough you’re in a frictionless environment, kinda like a perfectly functioning exchange.

But, I am still waiting for the physicist who can tell me for sure whether or not its going to rain tomorrow. And, they have satellites that can see the rain clouds coming!

That’s because weather, like micro level  human behavior is chaotic. That doesn’t mean we can’t make any predications but it does mean that making predictions is hard.

I find it particularly odd that Manzi agrees with this statement by Sullivan

We can try to understand previous examples; we can examine large randomized trials; but in the end, we have to make a judgment about the timeliness and effectiveness of certain changes. It is the ability to sense when such a moment is ripe that we used to call statesmanship. It is that quality that no wonkery can ever replace.

It is why we elect people and not algorithms.

Since one of, if not the greatest, contributions of economics to humanity is the highly non-obvious insight that no amount of human level judgment can hope to replicate market mechanisms.

Its important to remember that this is not the claim of Jeffersonian Liberals. They were concerned that a ruler would use unfettered power to oppress his subjects. It was social scientists who told us that even the benevolent king, even Aristotle’s philosopher-king, could not handle the information problem that free markets solve.

From the LA Times:

Here we go again. Another legislative session, another well-funded campaign waged by Intuit Corp. to abolish California’s free, innovative and wildly popular electronic tax filing programs, ReadyReturn and CalFile.

These two programs provide California taxpayers with a reliable, voluntary, safe and free way to calculate and file their taxes. ReadyReturn offers an already completed state tax return using information in the state’s possession (from a W-2, for instance) as a starting point. It’s for single filers whose income, up to $240,000, comes only from wages. CalFile offers free, interview-style online filing for somewhat more complicated tax situations. It’s for married as well as single taxpayers with incomes up to $320,000. The state estimates that 6.4 million Californians are eligible for these services — more than 40% of the state’s taxpayers.

There seems to be an efficiency gain here, as the reactions from people include things like:


Of course, as we all know, there is no free lunch. However, it is in the public’s interest to invest in ways to minimize the deadweight loss of collecting taxes (not to mention it’s a very “liberaltarian” thing to do), and it seems that California has found a more optimal solution than using TurboTax. Sadly, it is the norm for corporations which are becoming obsolete to seek refuge from the government, rather than adapt to a changing marketplace.

Picking up from Adam. So, Jamie Galbraith actually echoes a lot of the things I have said

  • Deficit Projections are mechanical and of limited use
  • Market interest rates aren’t forecasting a deficit crisis
  • The projections for Medicare / Medicaid are just nuts
  • There is no more reason to be concerned about unfunded Entitlements than unfunded Defense, unfunded FBI agents or unfunded trips to Mars.

However, he also says some things that make me go WOAH!

  • If the market is irrational then don’t worry because you can’t please an irrational beast
  • Deficits are the only way to inject financial resources into the economy
  • Government does not need money to spend just as a bowling alley does not run out of points.


I want to go through these briefly.

Deficit Projections: Its not unreasonable to try look ahead to the future and see what trouble might be coming your way. It is unreasonable to get all twisted in knots over projections of things that might happen 25 years or more into the future.

Twenty-five years ago we were just coming to accept that there seemed to be a productivity slowdown and all of our forecasts were wrong. Since that time the productivity slowdown has come and gone. An entirely new source of growth, IT, has been created and we are seeing unprecedented gains in wealth. Let’s try to be a little humble in guessing what the next 25 years will bring.

Markets don’t see a problem: Look markets are wrong sometimes – sure. But, that’s not the question. The question is: why do you think you know any better. That is, however bad the market’s analysis is, I am betting yours is worse. That’s why you haven’t taken over the world Warren Buffet style.

The reason markets get it wrong is because its hard to get it right. Lesson: be humble

Medicare / Medicaid Projections Nuts: First, Galbraith has something of a point about there not being a consistent story. As health care becomes a larger fraction of the economy, then mechanically excess cost growth must decline. That is, if medicine keeps growing it will take over the economy and then economic growth and the growth of medicine will be one and the same.

Now, in truth things can get pretty hairy before that scenario takes over. I just don’t think they are likely to get that hairy. Someone has to choose to keep paying these medical costs. Its not like the Medical Industry is the Mob and can keep shaking us down for everything we got. At some point you just say “Uh, no”

Either this will happen because insurance premiums get to the point where consumers balk or it happens because consumers demand government pay for their health care in which case government just clamps down in the US like it does in Europe and Canada.

So the problem is not that we are going to have spend all this money on the orgy of medical care that’s coming. The problem is that this orgy of medical care will have to come to an end.

Unfunded: So a big deal is made out of unfunded entitlements but, entitlements are not a liability. That is, future Social Security and Medicare recipients have no contractual right to those payments. Now we might have good reasons for wanting to pay them. We might also have good reason for wanting to have a top notch military, or a competent police force, or infrastructure or all the other things that government buys.

Zeroing in on this one expenditure doesn’t really make a lot of sense. Its not immediately clear to me that Congress has more stomach for cutting say Defense appropriations than Social Security. Thus there is no reason to be more concerned about future SS spending than future military spending.

Other the other side, however:

Irrational Beast: If you believe that the market is irrational that doesn’t imply that you should ignore it. There are consequences to what the market believes. Even if God whispered into my ear and told me what GDP was going to be 10 years from now I would still have to be concerned about current bond rates.

Upshot: the fact that market confidence is with us is good. If it looks to be turning against us then we should in fact be concerned.

Deficits are the Only Way: I am not even sure where he is getting this. Is he saying that the Fed can’t print money unless there is a budget deficit because that is just wrong. The Fed has to buy some asset but it can trade old Treasuries and in theory Agencies.

Government Doesn’t Need Money: I think Krugman did a fair takedown on this one. No, you can’t just print your way to prosperity indefinitely. There are times when you can print, yes. There are even times when printing is required for prosperity. However, its not an endless pit. Demand does not create its own Supply. When there is an output gap, as there is now, increasing Demand can raise Supply. However, once the economy is at full employment you can’t create resources just by printing money.

Rich Lowry, among others, argues that uncertainty surrounding the Administration’s policies is holding back entrepreneurship. This is an interesting and important question for economists to look at. Its also the type of identification quandary that is so sexy right now in the profession.

Until that good work is done, however, my priors are that it doesn’t really matter that much. I am sure there is some increase in uncertainty but if you look at the marginal uncertainty caused by administration policies relative to the deep inherent uncertainty associated starting a new business, its likely mild.

What really matters in my mind is real interest rates. One of the important things to consider is that businesses have a drop-dead point. That is, if money going in doesn’t keep up with money going out then at some point the business will drop-dead. Technically, we might think of this as a liquidity constraint.

Now, here is the interesting and twisted thing: First, the drop-dead point is related to interest rates. Interest is a big fixed cost. You have to pay the bank, bondholders, etc or they will force you to drop-dead. The higher the interest rate you pay, the less money you can borrow before you drop-dead.

Add to that, however, the fact that the interest rate that any individual business faces is related to how close they are to the drop-dead point. Banks are more reluctant to loan you money if they think you are going to drop-dead and thus need to be compensated with higher interest rates.

Thus, there is this positive feedback. The higher interest rates are the closer businesses are to dropping dead. Yet, the closer businesses are to dropping dead the higher the interest rates are that they individually face and thus they will be even closer to dropping dead. The relation keeps feeding back on itself.

If the feedback ratio is less than one this process will eventually halt and the business may survive, but it will be under a lot stress.  If the feedback ratio is one or greater the process will race off to the point where the business will drop dead with probability one (absolute certainty) no matter what its initial condition was. Thus, very interest sensitive businesses will collapse in the face of a credit crisis no matter how good their fundamentals are.

Smart readers who wonder about adding-up constraints will ask what happens to the excess supply for loanable funds as these feedback effects take off. Its soaked up by low interest rates on Treasuries, which is exactly what we see in a crisis.

This implies that you ought to get huge effects out of altering interest rates. That is, indeed what our empirics tell us. The surest driver of the economy, equity prices, home prices, employment, etc is the interest rate.

I say all of this to pull people’s attention back to the basic issue of real interest rates. Regular readers in the econo-blogosphere are well aware that we are up against the zero lower bound. That is, nominal interest rates can’t go any lower because they are already zero for the most creditworthy borrowers.

Dropping dead, however, depends on real interest rates, that is the nominal interest rate minus inflation. In everyday language it works like this. Imagine that inflation is 5% per year. Then so as long as you keep doing whatever is you are doing your revenues go up by 5% a year and your costs go up by 5% a year. Except that not all of your costs go up by 5% year. Your interest payments to the bank stay the same.

Thus, every year it becomes easier and easier to make your loan payment and your probability of dropping dead declines. Now, a bank thinking of loaning you money today knows that. It realizes this relationship between inflation and a borrower “growing into her payment” as its sometimes called. So, holding nominal rates constant an increase in inflation increases the credit worthiness of borrowers.

This is a factor that I would guess to be much, much larger than any marginal uncertainty about taxes. It also, why I keep wanting to drag the conversation back to monetary policy.

It so easy to get distracted by these practical seeming things like jobs skills, worker readjustment, taxes, etc because its easy to see how they can change.

Its not as easy to see how government policy will cause hundreds of thousands of uncreditworthy businesses to suddenly become creditworthy. Or equivalently , how it will cause millions of homeowners to suddenly be able to afford their mortgage, but that is exactly what the lever of monetary policy does.

What’s the big takeaway? We need higher inflation (and thus lower real interest rates) and we need higher inflation now.

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