Modeled Behavior

Feed Me

2009-07-07T09:46:00.002-05:00

So google tells me that more than twice as many of you are feeding this blog as my new blog.

Out with the old - in with the new: Get the New Modeled Behavior Feed

Back to Blogging - New Location

2009-06-12T13:02:00.002-05:00

I coming back to blogging on a permanent basis. I've moved to a new site and a new platform which I think we help integrate blogging with my academic responsibilities.

Now at http://modeledbehavior.com

Signaling Bags

2009-04-26T13:17:00.002-05:00

Ryan Avent asks why designers to produce knock-offs of their own products. Aren't the buyers of knowck-offs and originals two distinct markets?

The knock-off bag lowers demand for the real bag. Not because it steals customers but because it reduces the bags value as a signal.

To have a Prada bag is supposed to be a signal of both wealth and marginal utility of style. A high marginal utility of style in turn signals a high degree of knowledge or expertise.

That is you are not only wealthy enough to afford the bag but also value fashion enough and thus are likely to be knowledgeable about fashion. This means others should look to you for fashion cues.

Knock-offs reduce this signal and fashionistas have a harder time establishing themselves

The Credit Crisis is a Choice

2009-04-26T13:14:00.001-05:00

The credit crisis has moved beyond its initial stages. Virtually everyone has accepted this is a major global crisis. Virtually everyone has accepted that the core cause has been bad loans in which threaten to make the entire banking system insolvent.

However, now it is time to accept that the crisis is a matter of choice. The US government can effectively end a fair bit of the crisis immediately and can set us on the road towards healing. It can do this with two basic steps.

1) Making it clear that none of the major US money center banks, Well Fargo, Citigroup, Bank of America and JP Morgan; nor the two remaining major US investment banks Goldman Sach and Morgan Stanley; nor any of the major regional banks, US Bancorp, BB&T, etc. will be allowed to fail. None, no matter what.

2) Supplying credit and liquidity to the banks that is limited only by the bank’s tangible common equity, a measurement of strength that most banks get a good grade on.

My basic point for my more wonkish readers is that the US government can intermediate the entire global financial system if need be. That is the government, through the Fed, can print enough cash to keep lending going around the world. It can then “sterilize” these injections by issuing debt.

In short the government prints cash and then soaks it back up by issuing government bonds. The purpose of this round about action is to provide lending ability to banks. When the government prints money it does so by effectively loaning out newly created funds to the banks. Then the government borrows as much money as it loaned out, so the total amount of cash is unchanged.

The result is that the buyers of US government debt are effectively loaning their money to the banks who are in turn loaning it to consumers and businesses. However, the original savers are protected because the US government is effectively backing all of those loans.

This is not the way I would have preferred to solve the crisis. It involves the taxpayer taking on all the risk and effectively subsidizing the entire banking system. However, public outrage over direct government investment in the banks means that the good solutions are not available.

We should accept this and move on. We have the tools to end the crisis and we should use them.

Why Do We Need Private Investors

2009-03-24T13:12:00.003-05:00

Felix Salmon asks why we need to cut private managers in on the deal when all of the risk is systemic. What good does it do to have the best bond pickers out there when all the bonds will rise and fall together.

My Answer: Political Cover.

Most of the public is under the notion that the government is incompetent. Even when the government is staffed with former CEOs of major financial firms there is a sense that once they become employed by the government they loose all of their former skills and knowledge.

So, how to get around people saying "See, I knew the government would screw this up?" Pull Bill Gross and Warren Buffet into the deal. If it goes bad, Obama just stands back and points at Buffet and says "how could we have done any better, even the master was fooled"

Bailouts and the Marginal Tax Payer

2009-03-24T10:29:00.000-05:00

So here is meme that I want to question: "Our biggest concern about the bailouts is that taxpayers will wind up giving money to Wall Street firms or other big corporations."

This meme exists on both the left and the right though the lens each side see it through is a bit different.

However, who is actually paying for the bailout. Is it "The Taxpayer?"

Well, not exactly. Its not the tax payer in general, its what economists would call the "marginal" tax payer.

What does that mean?

Well no matter what most of us are going to pay some taxes. The bailout doesn't change that. The questions is whether or not we will have to pay more taxes. But when taxes go up, not everyone's taxes go up.

So the real question is - If taxes go up, who will wind up paying more taxes?

The last attempt to pay down the government debt was the Deficit Reduction Act of 1993. It was incidentally very successful. It worked in large part by raising taxes. But raising taxes on whom?

The act had a number of provisions but almost all the revenue increases were driven by two of them

1) The creation of a new 36% tax bracket for those making more than 140K (205K in 2009 dollars)

2) The creation of a new 39.6% tax bracket for those making more than 250K (367K in 2009 dollars)

So the last attempt to pay down the debt was paid for almost entirely by tax increases on those making more than 200K in 2009 dollars.

Then who payed down the debt built up in the 1970s and 1980s? Americans making more than 200K did. For everyone else taxes pretty much stayed the same and so it didn't really matter that all of that debt had be built up over the years.

Fast forward to today when we are worried about giving too much taxpayer money to big corporations. This implicitly represents transferring money from taxpayers to the owners, the shareholders, of those companies.

So one question is, who are those shareholders? Well according to the census bureau 91% of all households making more 150K owned stock. The last year of data is 1998 which was more than 10 years ago. Its probably a safe bet that the percentage is even higher today, perhaps approaching 100%.

The conclusion then is taking money from "taxpayers" to give to "big corporations" in large part is taking money from Americans who make more than 200K to give to Americans making more than 200K.

Of course because young people with much lower incomes also tend to own stock this could be seen as taking money from older Americans making more than 200K and giving to younger Americans of all income levels.

However, I suspect that the big tax increases to pay down the debt will only come after some number of years. At that time those lower income young people will have become the higher income older Americans. In a real sense the government will have given to them as young investors and turned around and taken from them as older investors.

This may make it seem like all the government is doing is an exercise in futility, but not quite. If the government can use money today to repair shareholder's investments today and then turn around and tax those same shareholders tomorrow, it may leave the whole nation better off.

Thats because the current corporate collapse is a self-feeding phenomenon that leaves idle resources and unemployed workers. If it continues there will be less total profit over this entire period because a big chunk of that period will have been spent with factories that are not running and workers that are not working.

Now, I don't want to overstate the case. There are still serious distributional issues associated with what the government is doing. However, it may not be as cut and dry as the basic analysis would make it seem. The population of taxpayers and owners of corporations is not as disparate as it may seem.

What to do about the Banks

2009-02-21T04:19:00.001-05:00

The more I think about it, the collapsing market value of big US banks may render the brouhaha over nationalization moot.

The government could simply make the following clear

1) There will be no more sweetheart capital injections into the big banks

2) They can be bought by the government at a reasonable premium to current trading price or they can fend for themselves

We can let the shareholders take it from there.

My guess is that they will force management to take the deal. If they don't it is because management can convince the shareholders that the bank can make it own its own.

In this scenario the government probably overpays for Citi for example, since the stock is probably intrinsically worthless and only trades above zero on the possibility of more government injections. However, right now Citi only costs $10B.

While that's not nothing, it may be a small price to pay to avoid a national food fight over whether the government is unjustly seizing private interests.

Once the bank is fully owned by the government it can be recapitalized. Now the government can inject as much money as it wants and all the profit winds up coming back to the government.

In theory we don't even have to change management. We don't have to do anything at all that disrupts the day-to-day operation of the bank. We are merely changing shareholders, something that happens everyday with bank employees or customers thinking much about it.

Is Obama's Mortgage Subsidy Bad Simply Beause Its Obvious

2009-02-19T15:12:00.000-05:00

By now you may have heard that part of the President's plan to deal with the housing crisis is for the government to subsidize subprime mortgage modifications. That is, if the lender will agree to lower the payment to a predetermined affordable amount the government will make up part of the difference.

The goal is to prevent foreclosures. A little know secret is that lenders often, indeed typically, modify loan terms when a payee gets behind. However, this happens only if the payee can show that he or she can make the new payments and not get behind again.

Well, the problem now is that people are so underwater many cannot even make the typical modified payments. So, the administration is stepping in.

This proposal, however, has drawn ire from the financial and economic communities. It is very clearly a subsidy from those who are making their mortgage payments to those who are not. It rewards people who took excessive risk, either by getting a mortgage that was too big or opting for a payment schedule that would including rapidly rising rates.

However, before we get too upset, too quickly shouldn't we wonder whether this isn't simply a more explicit version of the Wall Street bailout that the financial community supported almost universally.

On the one hand, Wall Street firms had to turn over stock and stock options to the government in exchange for their funds, while the these mortgagees will be getting the money with no strings attached.

On the other hand, however, the terms of the Wall Street bailout were much more favorable than anything those firms could have received in the private market. Indeed, that was the point. The government was the investor of last resort.

We favored that plan not because the banks deserved it, but because the consquences of not doing it outweighed the costs. We were risking systemic failure if we did not act and it was not sensible to cut off our nose to spite our face.

So, shouldn't we at least measure the subprime subsidy on those same terms. Will it save taxpayers on average more than $75 Billion? Will it slow the tide of foreclosures, bank writedowns and institutional bailouts enough that the nation as a whole makes it money back?

I don't know the answer to that question, but shouldn't that be basis of our analysis? Desperate times call for clear, rational solutions. We quite simply can't afford to indulge our emotions, whether it is sympathy for those who will loose their homes or anger at those who took on more than they could handle.

Negative Nominal Rates

2008-09-18T12:45:00.002-05:00

I mention a while back that T-Bills rates could easily go negative and they have. We are now experiencing exactly the type of scenario that could produce fairly deep negative rates, perhaps 0.5% or more if things get bad.

Right now, there is what seems to be a run on money market accounts. These accounts function as checking accounts for large investors, a place to hold cash you need ready access to. Unfortunately, some of that cash was invested in very short term bonds from Lehman Brothers. Fear, that these short term loans will not be repaid on time or that other companies might be late on payments people are taking their money out of money market accounts.

It has to go somewhere and since you can't hold cash, you hold T-Bills. I agree with Krugman that it is both intellectually fascinating and personally frightening to see negative these rates can get.

Reverse Bradely Effect

2008-08-11T10:34:00.002-05:00

538 points out that Barack Obama actually outperforms polls on election day. Typically, political campiagns expect minority candidates to under-preform polls because there is a sliver of voters who harbor some racists sentiments but are not willing to admit those sentiments to pollsters. The phenomenon is know as the Bradley effect in reference to Tom Bradely, a black Los Angeles mayor, who lost the race for Governor of California despite a lead in the polls going into election night, and projections by media outlets that he had won.

Obama on the other hand seems to do better than his polls would suggest. My guess is that both the orginal Bradley effect and the new Obama effect don't have as much to do with lieing but with emotionality at the voting booth.

In Obama's case he outperforms in areas with high black populations.

In those areas there is likely some fraction of the black population that on election night was seriously considering voting for Hillary Clinton. However, once inside the voting booth, the emotiona force of a potential black president overwhelmed their issue based calculation and they cast a vote for Obama.

Remember that voting itself is not rational unless there is some emotional reward for doing so. It is highly unlikely that any single voter will swing the election. Therefore, voters vote more for emotional reasons: civic duty, patriotism, boredom, the right to through it non-voters faces, etc.

An interesting study, I believe, would be testing whether or not there is a general Obama Effect, that the candidate who has more emotional connection outperforms his polls.

A simple test might be whether or not likability ratings predict overperformance. We know that more likable canididate, get more votes. However, are they more likely to get even more votes than they are forecast to get?

The Gas Tax Debate Matters

2008-05-08T15:07:00.002-05:00

Paul Krugman says that the Clinton / Obama division on the gas tax holiday doesn't matter. Clinton sides with John McCain in proposing a temporary reduction in the gas tax. Obama sides with economists in suggesting that its a silly idea.

There were three stages of importance to Obama's rejection of the gas tax and at each stage I was impressed and drawn to the Senator.

1) Obama was willing to go against both the conservative notion that taxes should be cut anywhere and always and the liberal notion that anything which on first blush would seem to lower costs for poor people is good. This says a lot about his efforts and forging a new kind of governance. Efforts that I was largely cynical about -- until now.

2) He was able to explain the gist of a relatively complicated (for TV) economic concept so that it was accessible to the average American.

3) He actually won with it. The gas tax debate did not seem to hurt in the polls and of course he won a commanding victory in NC. This means that he spoke truth to the laity and wasn't crucified for it. If nothing else this is talent.

I am intrigued and looking forward to seeing what else this man can do.

Why Democrats are Better on the Economy

2008-04-03T14:15:00.002-05:00

A striking empirical regularity is emerging. The US economy experiences better growth and less inequality under Democratic presidents.

Like Paul Krugman I have typically dismissed this as a likely statistical aberration because I could not think of how presidents, democrat or otherwise could affect the economy in the near term. Unlike Paul I have spent most of my life as a Republican and so I have been somewhat hesitant to accept the regularity as well.

However, the data is the data and until it is overturned it is up to us to explain it.

I should not that in the finance literature I have also seen articles purporting higher returns in equity markets during democratic administrations - so it doesn't seem to be class warfare.

My Guess: Lower risk premiums.

What the President can do in the short term to benefit wages and equity prices is reduce risk. If the President handles national and international crises with more adeptly then we should see lower risk premiums, and a greater investments in capital and labor. This should drive up equity prices and wages.

Why $10 for BSC is an Abomination

2008-03-27T11:44:00.003-05:00

This is exactly what we wanted to prevent

T-Bill Rates Can Be Negative

2008-03-26T13:01:00.006-05:00

Yes, Virginia T-Bill rates can be negative.

In economic theory and practice we typically consider this an impossibility because agents would prefer to hold cash.

However, holding cash is not costless - particularly not now. Holding physical cash in the quantities needed by hedge funds and sovereign wealth funds has obvious costs. You have to build a vault, guard the vault, protect against employee theft, etc.

However, cash accounts at financial institutions also impose a cost if you believe that there is a liquidity crisis in the works. If a bank or investment house fails, then at best your account is likely to be frozen for some period of time. At worst you may suffer permanent losses.

If it turns out that you can't hold physical cash, you are nervous about large cash accounts and similar liquid markers such as Auction Rate Securities are seizing up, then it might be worth it to pay the US government hold your cash.

Now, I don't think that T-Bill rates will go negative because I think that banks, who can realistically hold high quantities physical cash will sell them aggressively. Yet, it is important note (in answer to Krugman's query) that if bank holdings are the channel by which the T-Bill rate stays above zero then monetary policy is not impotent in a zero rate T-Bill world.

$2 - No more no less

2008-03-24T09:48:00.004-05:00

~~Rumor is~~ JP Morgan is ~~thinking about~~ upping the ante on the Bear Stearns deal to help it go through. The Fed should discourage this.

The original sale price of Bear was $2 a share and represented a virtual wipe out of Bear shareholders. Given the extensive role the Fed played in staving off bankruptcy this was appropriate. The Fed should in no way signal that it is prepared to step in to save stockholders. It should step in only to assure smooth functioning of credit markets.

However, now JP Morgan seems to be caving from pressure from Bear shareholders who may vote down the deal out of spite. The Fed cannot stop this directly but it can issue statements which imply its approval of the $2 price.

I would say something like:

The funding and guarantees offered by the Fed were supported by JP Morgan's unique ability to provide stable assurances to Bear Stearn's clients, creditors and counterparties. We anticipate that few other situations could have or will justify such measures.

In other words, Bear shareholders are lucky to have $2. Please do not make things worse than they already are.

An Offer They Can't Refuse

2008-03-21T11:18:00.002-05:00

What options do we have for stimulating the economy once T-Bills rates hit zero? Traditionally, the Fed encourages bank lending by buying T-Bills.

The Federal government limints the amount of loans a bank can give out based on the amount of cash they have in the vault. So each day the bank has to decide to

A) Keep money in the vault and use it to support new loans to customers

B) Loan out the vault cash to other banks

C) Loan the vault cash to the Federal government by buying government bonds also known as T-Bills

To stimulate the economy the Federal reserve buys up T-Bills. This lowers the interest rate on T-Bills and encourages banks to try to lend more to each other. However, on net inter-bank lending must be zero. That is, every loan to one bank must be matched by borrowing by another bank.

When too many banks try to lend to each other at once the interest rate on interbank lending, the federal funds rate, falls. This leaves the banks with only one good option - lend more to customers. And that exactly what we want.

What happens, however, if the interest rate on T-Bills goes to zero. Then even if the Federal Reserve buys more T-Bills it doesn't encourage banks to lend more to each other. Thats because the Fed is not making T-Bills less attractive. Zero is still zero.

One question might be, "If the interest rate on T-Bills is zero but the Fed funds rate is not zero, then why would ever buy T-Bills."

The answer is that T-Bills are backed by the full faith and credit of the US government. When a bank loans to another bank it has the full faith and credit of that bank, but in this environment the banks don't have the same kind of credit they used to.

So what can the Fed do to get around this?

It can lend to the banks directly. Currently the Fed charges more to lend money to banks than banks charge each other. Thats because the Fed only wants lend as a last resort.

However, the Fed could change that and make borrowing from the Fed just as attractive as borrowing from other banks.

Some economists worry that banks will be hesitant to borrow from the Fed because typcially that is seen as a last resort and no bank wants to look desperate.

However, as the cost of borrowing from the Fed goes to zero and possibly even (gasp) below zero banks will change their minds. Indeed, they will probably all change their minds at once in what researchers think of as a tipping point.

The question is how do we manage that tipping point. One way is to make the loans a temporary feature. The Fed can allow temporary loans for up to 28 days and less than say $50 billion at this super low rate. Then it can judge participation and if necessary offer new loans when the 28 days is up.

If these rates are low enough banks will find them irresistible. Its possible that for short periods the Fed could even loan out money at negative rates. That means the Fed pays banks for taking out a loan. Thats an offer that few banks could refuse.

How Low Can She Go - Do We Even Know?

2008-03-19T13:30:00.004-05:00

KNZN mentioned that he didn't think real yields could collapse enough to produce a liquidity trap in an inflationary environment.

The 90 day T-Bill is now at half of a percent, and looks to be in freefall. Remember this is after the Fed annouced that I-Banks would have access to the discount window and that Bear Stearns was brougt back from the brink of bankruptcy.

Had Bear gone under could interest rates have remained above zero?

There is no tightrope. We should starting talking about making the financial sector an offer it cannot refuse. More on that tomorrow.

100 Basis Points

2008-03-18T10:23:00.002-05:00

I am off to the state legislature this morning so no faux statement. However, I still maintain that there is no tightrope. The Fed has to be focused on preventing the liqudity trap and jump starting credit markets as soon as possible.

Moreover, M1 is flat and credit contracting. This should be leading to an effective decline in the money supply. Ultimately that is deflationary.

The statement should have some nod to commodity prices and risks but the predominate concern is stability in financial markets and the outlook for growth. In short, look out below, we are heading for 1% as fast as is prudent.

Note to Markets: Credit Will Be Saved - Equity Skewered

2008-03-17T12:15:00.002-05:00

I am a big fan of what appears to have gone down in the Fed - JPMorgan - Bear Sterns deal. It worked out just about as well as it could given the situation.

Bear Stearns shareholders lost everything, which helps prevents moral hazard. Creditors, counterparties and clients were saved which keeps the financial system functioning.

When the dust settles this could be one central bankings finest moments.

Bang Up Job Guys

2008-03-15T09:23:00.010-05:00

You really have got to hand it to the financial press. After stoking the fires of risk fueled housing and equity bull markets they have now fully transitioned into fanning the flames of widespread panic.

Its a wonder that more banks don't tap the discount window after the confidence inspiring conniption that virtually every financial pundit seemed to go through yesterday.

Was there a major crisis at Bear, of course. By no means am I suggesting anything less. However, the term "FED Bailout!!!" was splashed across every TV and computer screen that I saw, when the reality was somewhat more prosaic.

About three-quarters of the way down this Wall Street Journal article the author admits that

technically the Fed still hasn't lent directly to investment
bank

because

the New York Federal Reserve Bank had agreed that it would provide financing to Bear Stearns via J.P. Morgan Chase. J.P. Morgan Chase was used as a conduit because, as a commercial bank, it already has access to the Fed's discount window

So basically, as I see it, the Fed encouraged JP Morgan to use the discount window essentially as intended - to stem a bank run.

Now, it wasn't a bank that was being run but in our modern financial system the Fed understands that intermediation extends far beyond traditional banking institutions. Yet, the Fed still went through a member bank to conduct this operation so as to avoid mudding the waters as much as possible.

As far as I can tell the big innovation was that Fed guaranteed Morgan against losses, which given the time frame available seems not only prudent but reasonable.

Liquidity Trap, Delfation, ZLB

2008-03-14T09:33:00.003-05:00

Lots of people have said to me both on and off line that we don't have to worry about the Japan Scenario because we have a solid inflation buffer in the US.

While the inflation buffer gives us more room in a sense, it is important to remember that it is not deflation per se that causes a liquidity trap. It is that the equilibrium interest rate is below zero.

It is possible that the equilibrium risk free interest rate is a real negative 3% in this crisis, which implies that we still won't be able to get there with 2.7% inflation.

Exploding risk premiums could drive the equilibrium real rate that low because what matters is credit availability to firms and consumers.

So we are not in a position were we can ignore the liquidity trap possibility. On top of that is the issue that there are increasing deflation pressures in the decline collateral values, falling consumption and the potential for dramatically slower global growth. While ultimately they might not override inflationary effects of recent Fed policy, they are not to be ignored.

In short deflation cannot be ruled out and the liquidity trap remains a threat even in a moderately inflationary environment.

Immaculate Inflation

2008-03-14T08:06:00.002-05:00

Some of my fellow bloggers have been looking at inflation expectations and are worried that the Fed is pumping too much cash.

I am skeptical.

Inflation ultimately has to come through the interaction of supply and demand. Money creation may be the source of surging demand and hence higher prices but demand has to in fact surge. It is difficult to have Fed driven inflation in an environment of falling retail sales.

If consumers contract then businesses loose pricing power. Commodities ultimately have to follow business demand.

Mo' Better

2008-03-10T10:29:00.002-05:00

I may be one of the few bloggers who think the Feds policy actions are now moving in exactly the right direction. My long standing view is that we are experiencing the popping of a massive credit bubble that extends far beyond subprime mortgages.

A credit bubble happens when the price of credit becomes to low rather than too high. Low priced credit like asset bubbles can be self-reinforcing. Cheap credit means that people can easily refinance their old debts. This puts more money back into the market at lower risk levels which further encourages cheap credit.

See, essentially the price of credit is determined by two things. First, is the scarcity of money. When you loan someone money, you can't use it to buy things yourself. Therefore, few people want to loan out all of the money they have. However, if the government prints more money, more can be loaned out without running short.

Controlling the quantity and hence the scarcity of money is usually what the Fed does to control the price of credit.

However, there is another factor, default risk. Even if you didn't need your money right now you might be hesitant to loan it out if you thought you wouldn't get it back. Hence, the price of credit rises when people think they might not be repaid. The difference between the price of risk free loans and risky loans is the credit spread.

So, how does this affect the current situation. The subprime explosion and subsequent implosion happened because of collapsing credit spreads. That is, investors stopped worrying as much about getting their money back. In particular they believed they had fancy computer simulations which assured that they could make money even if lots of the loans defaulted. As long many of them did not, it wouldn't be a problem.

Now it turns out that those simulations were based on a world in which credit was relatively hard to come by. This new world, in which investors were loaning to anyone with a pulse operated by different rules. In short, the computer simulations lead to the creation of a world in which the simulation was no longer valid.

Computers in some ways are like extreme autistics who often suffer from these types of recursive mistakes. They fail to realize that the response pattern of the outside world is dependent on the outside world's perception of the computer's response pattern. Thus an infinite cycle of you think, that I think, that you think, . . . is set up. Cognitively normal people can solve these problems intuitively but they form a serious calculation issue for computers and autistics. But, I digress.

The important thing is that the simulations failed to account for the changing nature of the credit market. Thus, investors took on way more risk than their analysis had predicted. In late 2006 and early 2007 it started to become clear that the analysis was wrong. By the summer of 2007 credit spreads were spiking as investors tried to undo what they had done.

The Fed, at first tried to fix the problem by increasing the supply of money. The hope was that this could drive down the price of credit, allow people to refinance and investors to get out of the bad deals they were in. However, the deals were going bad too fast. The Fed could not keep up and despite their best efforts spreads are growing again.

So what do?

The Fed must attack the credit spreads not just the scarcity of money. This is what it is doing now by taking an increasing variety of assets as collateral for up to $200 Billion in loans. What that means is that the Fed is allowing banks to borrow cold hard cash by using your risky asset as collateral. In addition, its going to keep rolling this loan over indefinitely.

This means that some of the risk has shifted from the bank to the Fed. If the asset goes bad and the bank can't repay its loan to the Fed, the Fed ends up with the bad asset. In a sense it implies that risky assets are only so risky because at the end of the day you can always pawn them off on the Fed.

Doesn't this put the Fed at risk? Well, the Fed buys the asset with money that it creates out of thin air. Things get a little complicated when one considers that the Fed has to also keep an eye on the Federal Funds rate, which it manages by creating money out of thin air. Yet, I don't think thats much of a problem. This post is already longer than I intended so why its not a problem will have to be saved for another day.

There is No Tightrope

2008-02-29T14:45:00.002-05:00

The analogy of Ben Bernanke walking a tightrope between a recession and inflation has become popular of late. However, I suspect that the Federal Reserve increasingly is coming to believe, as I do, that there is no tightrope.

Inflation is here, yes. Commodity prices in general and agricultural prices are skyrocketing. This is something that we talked about here last year. However, the Japanese Scenario is becoming more salient everyday.

As I say regularly to my colleagues, "This is not just sub-prime, this is not just housing. This will get much worse before it gets better"

I am sorry that I do not have the time to post lots of interesting graphs as evidence. What I am worried about, however, is a recession within a recession and the consquences for solvency in the financial sector.

So far there have been some very high losses associated mostly with subprime mortgages. However, this is potentially the tip of the iceberg. Much larger losses will could come from the set of mortgages known as Alt-A, along with consumer credit, commercial real estate loans and corporate loans.

Now, unlike subprime many of these loans will not experience high default rates in the absence of macro events such as declining home prices or rising unemployment. Therefore, those losses are starting to trickle in now. Alt-A today for example is probably at the same point in the rising default cycle as subprime in late 2006.

We see that home prices are falling but what about unemployment. If we look at the business cycle spikes in unemployment are typically led by a slowdown in residential construction and are accompanied by a drop in business investment spending. In fact by the time unemployment spikes residential construction is typically on its way back up.

This time may be different. Business investment is already slowing and unemployment rising. Yet, there is reason to believe that residential construction could fall throughout the rest of the year.

In a sense this means that we will be in the midst of a recession (high unemployment), at the same time that we are experiencing leading indications of a recession (construction slowdown). This sets up the possibility for a vicious cycle in which unemployment further depresses housing which leads to even greater unemployment, or a recession within a recession.

This scenario must be avoided. The Fed should acknowledge that inflation is a problem but should begin to brace the nation for a policy designed to beat back a Japanese style depression without regard for the immediate implications for inflation.

It Only Seems That Way

2008-02-01T13:51:00.001-05:00

"Why would you ever want to take on more debt than your home is worth," ask Mike.

The short answer is that when you think liquidity is going to be a problem it is always better to have money in the bank and higher debt than no money in the bank and lower debt.

A longer answer is that people often think of taking out loans so that you can buy something you want. Ultimately, this is what most people do with borrowed money. However, you can also take out loans just to have more cash in the bank.

This is what I suggested that homeowners do. You never know when you will have an emergency, loose your job, etc. If you have credit available then you can whether those situations. If not, then you may be forced into dire straits such as foreclosure.

Therefore, if you think your credit is about to dry up, its always in your interest to pull out the money now. You can put it into a high yield savings account. If you never use it then you only owe the difference between the interest you are paying and the interest you are getting.

If you do use it then it could save you.

Now, thats the responsible take. Their is a less responsible corollary. That is, if you are planning to spend way beyond your means then you might as well borrow that money at 8% from your home equity line of credit, rather than 23% from your credit card.

In either case, it is better to borrow cheap easy money then be stuck borrowing expensive money or being short of money.

Of course, it would be better still to save responsibly and be lucky enough not to have an emergency. However, many people who have decided to live beyond their means are not going to stop until they are insolvent and almost by definition its difficult to control emergencies.

I don't know if that helps, but its important not to confuse borrowing with spending. Borrowing is a lot of money is imprudent. Spending a lot of money is imprudent.

Last Straw for the Consumer

2008-01-31T20:26:00.000-05:00

A while back I suggested that smart homeowners were loading up their HELOCs before the door was shut. Turns out the door is being shut on Monday. Calculted Risk reports that both Chase and Countrywide are placing new limits on how much consumers can borrow.

Without access to Mortgage Equity can the consumer continue. Moreover, consider the on going possibility that high US consumption is being driven by a minority of consumers who have been drawing on heavily on home equity. With the door shut on those high spending consumers we could see a dramatic realignment in the US savings rate and with that a global recession.

50 Bps ???????

2008-01-30T09:07:00.000-05:00

I am at a loss for the move today. On the one hand I think the Fed can safely cut 50 without spooking the markets. There is a hope at least that swift cutting now can avoid us having to go all the way to zero if the recession gets out of hand. Remember that we went to 1% last time and we started from a higher funds rate.

On the other hand the SocGen incident has to be a little embarrassing personally for the FOMC. There is certainly the sense that they may have been jumping at shadows. This argues for 25 bps if any.

At the end of the day, however, avoiding the Japan type scenario has got to be the priority. And, with slowing global growth inflation concerns may be moderating so. 50 bps and say something like:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

In recent months the outlook for growth has weakened. Credit markets have remained strained and the slowdown in housing has continued to diminish output growth. Some businesses and households are finding it more difficult to obtain credit.

Commodity prices have moderated in recent weeks and inflation pressure appear to be weakening. Nonetheless, the committee will monitor incoming data for signs of increases in inflation expectations.

Some downside risks to growth remain. The committee is monitoring incoming data as it becomes available and is prepared to act in a timely manner to address those risks.

Notes:
Acknowledgment that oil prices are retreating. Direct references to financial institutions removed. Appreciable downside risk becomes some downside risk.

Did The Fed Cater to Wall Street

2008-01-23T12:10:00.001-05:00

Do I think anyone on the Federal Open Market Committee said "Look these losses in the stock market are unacceptable we need to move" - no I don't.

Was there concern that widespread panic was ensuing that would result in a capital market freezing up - likely. Moreover, it was a sign that market participants were significantly increasing the likelihood of a major financial institution failing, this concerns the Fed deeply.

Look, I was shocked at the move and I am not certain that it was the right thing. Only hindsight can tell. However, we had started to get conclusive data that the US was slipping into recession. Because credit quality is already slipping a US recession is likely to be self-reinforcing.

That is, high unemployment leads to more foreclosures which leads to less lending which leads to higher unemployment.

So there was definitely a need to act. Last week I was even open to 75bps at the Jan 30 meeting. My biggest concern was spooking the market. But, the market was already spooked, so no loss there. So I believe the cut was designed to stem the recession. The collapse in equity markets was a sign that the recession was worsening and could itself contribute to the recession if it resulted in less spending or lending.

However, that being said the members of the FOMC are human. It was hard to watch the entire world selling off and not do something. I mean you could see that markets tumble literally as the world turned. As soon as daylight hit a region, it was in the red.

As for the ECB's tough talk. Number one, they do not have a dual mandate. Technically, they are responsible only for managing inflation not unemployment. However, I also think they are somewhat in denial. We have seen this before. We saw Japanese central bankers in the early 90s in denial about how bad it could get.

What we are looking at are severe downside risks and now it the best time to stop them. If a Japan type scenario is on deck for the US, this would be the time to prevent it. So while the move shocked me, I understand it.

I am sure Bernanke does not want to leave his post wondering if he stood by while the same forces that engulfed Japan, take down the US. If that means that he has to risk his rep now, I am guessing he says, so be it.

Rate Cuts and You

2008-01-22T13:27:00.000-05:00

Mike asks how the rate cuts will help the common man. In some ways this question cuts to the heart of monetary theory and policy. In principle the sole purpose of monetary policy should be to help the common man. Is that whats going on now.

Yes, and no. Its very very tempting for the monetary authority to focus heavily on assets prices and as such the upper class. You get instant feedback about expectations, liquidity, and overall wealth by looking a equity and credit markets.

To find out whats happening to the Joe on the street takes years and even then we are often not sure if we have the right metrics. Moreover, Wall Street is often clamoring for help while the Joe Sixpack may not even know what the Fed is.

However, cuts (and hikes) do wind up having their biggest effect on the weakest members of society.

Why?

Because, those members are the most vulnerable to inflation and unemployment. When the Fed cuts now the hope is threefold.

1) This will lead to more favorable mortgage and credit card rates which will relieve the payment stress on average consumers

2) That if consumers can slowly, rather than dramatically reduce spending growth (as they must) then businesses can adjust without resorting to mass layoffs.

3) That we can ease pressure on the banking system so that more people and businesses will be able to get credit when they need it.

All of these things should ease the stress on the common man. The reason I did not believe we would have cuts this morning and some economists are upset about them is because it looked as if the Fed was going to far to stem losses in financial markets.

This is a really hard call because losses in financial markets can lead to pains for the average worker if it means that corporations have a hard time raising capital and need to instead turn to layoffs.

At the same time, however, more vulnerable Americans who have relatively fixed incomes are susceptible to inflation and there is some evidence that inflation causes the entire system to be sluggish. Not to mention the problem of encouraging financial speculators to take risks if they believe the Fed will bail them out.

So, the upshot is that the cuts should reduce some stresses on average people and hopefully reduce painful layoffs.

Bernanke needs to Speak Tomorrow Before the Open

2008-01-21T21:11:00.000-05:00

if this continues . . .

The key word is promptly. The Fed is prepared to act promptly to signs of further deterioration in output and employment.

Further the Fed is prepared to act to support the smooth provision of credit and stability in financial markets consistent with the dual mandate.

50 now and hints at Intermeeting Cut

2008-01-21T09:24:00.000-05:00

I'll put up a more definitive rate preference and statement later, but right now I lean towards:

1) Cutting 50 bps on the 30th

2) Saying something like "The Committee is monitoring the data closely and is prepared to act promptly to increasing signs of deterioration in growth and employment"

A growing risk is now generalized, rather than simply asset, deflation. It is quite a difficult time for central bankers, when both inflation and deflation are credible risks.

This makes language crucial in communicating to the markets. In particular, participants need to know what the key data measures are so they can update their expectations. In particular I would point the markets towards unemployment and agricultural prices. Although these may not be leading indicators they are quite solid indicators of where the pressures are and we can feel more confident in taking large actions based upon them.

In particular if Ag prices fall I don't see how general inflation holds up in this environment. Not that Ag prices are pushing general inflation but they indicate a worldwide slowdown in demand growth.

Dark Matter in Action

2008-01-18T13:52:00.000-05:00

The Economist is concerned about Sovereign Wealth Funds and it appears Washington is as well. My personal reaction when I heard that international investors were pouring another 12.5 Billion into Citi on top of the 7.5 Billion they received at the end of last year was a bit different. This, I thought, is Dark Matter in action.

Dark Matter was a much ballyhooed hypothesis that the US could manage to run such large trade deficits because it was making a killing on its investments overseas. Think of it this way. Suppose you borrowed $100,000 at 5% interest. You took half of that money, $50,000, and blew it on a big screen TV, new stereo, trip to Thailand etc. You took the other $50,000 and invested it at 15% guaranteed.

So you end up having to pay $5,000 a year in interest, but you are receiving $7,500 in interest. On net are in debt? What does it mean to be a net debtor if you are actually taking in more money on your investments than you are paying out.

Yet, someone who looked at your spending habits would say, "you borrowed $50K and blew on junk, you must be in debt."

In a nutshell is the situation the US finds itself in. Went spent a bunch of borrowed money on junk but we managed to invest the rest at incredible rates - or so it seemed.

A more careful examination of the data revealed that it wasn't that the US was earning amazing returns on its investments. It was that foreigners were getting a lousy return on the money they loaned to us or otherwise invested in the US.

Which brings us back to Citi. Are foreigners swooping in to buy one of the US's venerable institutions at fire sale prices, or like the Mitsubishi purchase of Rockefeller Center, are they overpaying for a famous property that can no longer produce. My guess is that it is more the latter than the former.

On Going Issues

2008-01-14T13:46:00.000-05:00

1) On Thursday Bernanke started to use the kind of language that I was hoping he would use. Hints that the FED would be highly responsive to further deterioration. Thats the kind of assurance that helps smooth the non-linear waters of the market. Sometimes, a big move or the potential for a big move can have a stronger effect than several smaller moves of equal total magnitude.

2) We'll get retail sales tomorrow. Thats the last piece of the January data set I expected to justify strong action. If retail sales is as ominous as I suspect we should start talking about 50 bps with a strong bias towards cutting.

I am also not completely and totally immune to arguments that push 75bps. Though I would have substantial hesitation on many fronts including the risk of spooking the market. I don't think we have seen a cut above 50 bps since the early 1980s.

3) I have mixed feelings about the increasing realization that subprime was just the canary in the mine shaft. Alt-A mortgages, credit cards and CDS on corporate issues are next. There is some sense vindication in that this is turning out not to be a housing bubble but a credit bubble all around. However, of course it would have been better to be wrong.

What Bank of America Was Thinking

2008-01-11T11:50:00.000-05:00

I was on the inside of Bank of America for a while as a consultant. I signed a deal that said I wouldn't talk about anything I overheard for three years but it has been much longer than that and I am sure that my thoughts are generally old news. Nonetheless I think they are worth sharing.

Bank of America was heavily investing in Consumer Real Estate, thats what they call mortgages, when the subprime boom hit. The goal at The Bank, was to streamline the entire haphazard process of mortgage application and underwriting. In particular they wanted a single computer system that could automate the entire process. In the past there had be a hodge podge of different systems and departments that did everything from taking applications, to verifying income and assets, to making sure the house wasn't in a flood zone.

The idea here, and behind a lot what The Bank, was doing was that consumer banking was about information. Their real asset was that the mortgage application let them stick their noses in all of your nitty gritty financial information, which they could then use to sell you every product under the sun.

In particular a few key executives were really into this notion that The Bank could be a conduit for every imaginable service related to a home. Bank of America could arrange your lawn service, your pool service, your home security service, everything you wanted. And since, they knew so much about you they could figure out exactly what you wanted.

It was the fees on these service that were going to be real winners. So, what is The Bank getting when they buy Countrywide? They are getting the largest mortgage servicer in the country and access to lots of homeowners whom they plan to sell lots of other stuff to as well.

My concern, however, is this - Bank of America looks so responsible because they didn't really dip into the subprime waters like other banks. My feeling, however, is that this is because they already had a big project going when subprime came along and they didn't want to muddy the waters with this new poorly understood stuff.

However, The Bank is heavily into credit cards, which are going to be the next take a hit. The Bank also is taking on a lot of servicing responsibility with Countrywide. To the extent that
not just subprime but Alt-A and even adjustable rate prime mortgages start to go delinquent, The Bank is going to be responsible for advancing interest payments to the investors in those loans. That is a heck of a liquidity responsibility. I would like to hear more about how The Bank would fare if prime ARM delinquency rose substantially.

What Happened in New Hampshire

2008-01-09T14:04:00.000-05:00

There is a lot talk about what turned the tide for Hillary; the cry, the contrarian nature of New Hampshire, Chris Matthews, the debate.

Yet, in my mind I cant help but wonder how many women in Iowa were afraid to tell their husbands and boyfreinds that they supported Hillary. Caucus is out in public and subject to public pressures. Women may have decided to keep the peace rather than echo their support.

The when the pollster called New Hampshire the next day the state was swept up in Obama fever. By Tuesday, however, when women were all in alone in the voting booth and had to decide whether they were going to kill the hope of Hillary being president or let her live for the day, they went with their gut.

Will The Recession Be Outsourced?

2008-01-07T14:08:00.000-05:00

So, US consumption growth will decline - that much is clear. Indeed, in the short term consumption is likely to contract in real terms.

The quandary now is how much of that reduction in consumption will raise unemployment in the US. Traditionally, declines in consumption translate into declines in manufacturing employment. Yet, these days a smaller and smaller fraction of the US population is employed in manufacturing.

Can manufacturing still cause a recession when it employs only 10% of the workforce? Will the declines in employment cut deeply into the traditionally stable service sector? Or will the recession be outsourced? That is, will the decline in manufacturing jobs that typically accompanies a US recession really hit manufacturing employment in other countries.

My intuitive take is that the service sector will take an unprecedented hit but that much of the increase in unemployment will be exported. My pet theory is that we are moving into a strange world of recessions without large increases in unemployment.

The pain of the recession will be felt in asset declines, and workforce relocation. Workers will slide into lower paying less productive jobs but not on to the unemployment rolls. These working recessions will see declines in productivity and an evisceration of corporate profits.

But thats just a pet theory. Time will tell.

All For The Want of A Nail

2008-01-03T15:22:00.001-05:00

So, John Berry looks like the standard bearer for those who think the sub-prime crisis is overblown. So Berry says

A more realistic amount is probably half or less than those exaggerated projections -- say $150 billion. That's hardly chicken feed, though not nearly enough to sink the U.S. economy

There are a couple of problems here. One, Berry isn't factoring in the effect of declining collateral values when he says

First, the mortgages are backed by collateral, a house or condominium, and in a foreclosure a home typically retains significant value. When it is sold, the lender often will get 50 percent to 60 percent or more of the loan amount after foreclosure expenses.

That’s in world where the value of the home often exceeds the value of the loan. This is not where many of the defaulting sub-prime borrowers will find themselves.

More deeply, however, Berry is conflating losses with defaults. Indeed, a commenter on Naked Capitalism summed up the no-big-deal viewpoint nicely when he said

If for the want of a nail the battle is lost, then the battle can be won for the price of a nail.

This comes from a poem often used to describe the Butterfly Effect

For want of a nail a shoe was lost,
for want of a shoe a horse was lost,
for want of a horse a rider was lost,
for want of a rider a charge was lost,
for want of a charge a battle was lost,
for want of a battle the war was lost,
for want of the war the kingdom was lost,
and all for the want of a little horseshoe nail.

Berry and the commenter seem to be implying that a $150 Billion nail is not a hefty price for the US economy to pay. The problem, however, is that we don’t know which nail is bad.

This is the essence of risk.

If for example, we knew exactly which homeowners were going to default then we could correctly value each Mortgage Backed Security. Once, we had written them down for the value of the bad loans they would be AAA securities, since there is no remaining default risk. The CDOs which hold those securities could be written down, the SIVs that hold them could be written down and so forth until the $150 Billion had been distributed accordingly. We could then all go about our business as if nothing had happened.

Alas, this is not the situation we find ourselves in. We don’t know which nails are bad and we don’t have the resources to check every horseshoe. To make matters worse the CDO revolution convinced us that bad nails didn’t matter and so we went about shoeing horses like crazy and sending their riders into far flung battles around the world.

In other words, because there seemed to be little risk in making loans, we made lots of very risky loans and drove up asset prices on the basis of those loans. Now, the whole thing is supported on a foundation that is not only not as secure as we thought but due to lax underwriting standards, less secure than normal. So we have higher assets prices supported by weaker fundamentals. That’s a prescription for a fall.

The real question then is not, how much we will lose from defaults. The real question is how much of a return would we have demanded to risk these types of defaults and how low asset values have to fall before they can guarantee us that type of return.

For example, Berry estimates a 12% loss after default rate for subprime mortgages. Well that means that we have to shed 12% of the value just to bring us back to the expected return we had before. We have to shed much more than that to compensate investors for the fact that an individual security might lose a great deal more than 12%.

Even more stunning than that is the fact that the huge profits coming out of the financials drove increases in stock indicies. Now the financials are taking losses on the very securities that made them so profitable. This means not only is there less capital inside of those companies but that the run of profits we saw before was an illusion. It wasn’t possible to generate those types of returns without taking on lots of risk.

So we have a smaller company now with lower growth prospects. This implies quite a bit of fall in value.

Stack on top of that the fate of the US consumer. For a while now the consumer has been spending like gangbusters no matter what happened to the aggregate economy. Now, it seems that this spending was likely fueled by imprudent loans.

Going into detail about this requires another post, but imagine if the American spending spree was conducted by a small portion of the population spending way beyond their means. Now, imagine that this is the very population who is being foreclosed upon right now. It is at least possible then, that the American economy could swing from a negative savings rate to a more traditional savings rate very rapidly.

That is, imagine that most people are saving just as they were 25 years ago, but a select few have been borrowing so much that it drove the average savings rate negative. When those free speding few have their Home Equity Lines of Credit canceled, we will be left with only the spending of the traditional consumer.

In the long run that’s a good thing. In the short run it’s a very painful thing.

All of these possibilities are why the credit defaults imply asset value collapses that are much greater in magnitude.

Fed Credibility

2008-01-03T14:31:00.001-05:00

Henry Kaufman is significantly more critical than I am.

This post from Naked Capitalism is well worth the read.

In some sense Kaufman is saying that the market cannot be treated as an equal partner with the Fed when the market is in no position to bear the level of accountability the Fed must shoulder. The Fed can't make the market clean up its own messes because the market is not capable of doing so without damaging Main Street, the constituency the Fed is supposed to protect first.

Though it disturbs my liberaltarian sentiments, I find it difficult to disagree.

Precommitment

2007-12-31T20:32:00.000-05:00

Given some of what I have seen on the net I need to do a serious (much more than this) post on asset prices and defaults. I think some people are conflating the decline in asset values from the bursting of the credit bubble with the value of defaults.

Indeed the former is significantly larger than the first. For example, if I told you that a bond you thought was perfectly safe when you bought it for $100,000 actually had a 25% chance of being worthless what would you be willing to sell it for? I guessing much less that $75,000.

Now suppose that a financial enterprise you were invested in had been raking in big profits by buying these $100,000 bonds that now have a 25% chance of default, how much less do you think your investment would be worth. Remember that this not only includes the fact that the bonds are worth less but the realization that the supposed big profits in the past actually came from buying stuff that is a money loser today. What does that tell you about the potential for future profits and how would that effect your valuation of your investment?

Alarmism and Rational Panic

2007-12-31T20:25:00.000-05:00

Two commenters have pointed out that my last post seems excessively alarmist.

I think I may have obscured my own point. I am not attempting to get people to sell in a falling market, so much as admitting that the only honest advice I could give is to sell in a falling market. Given that I think people will eventually find their way to optimality, this indicates to me that the market response will be different than in times past.

There is good chance that the point will come where Floridians realize that to some extent this is a game of who can get out first. I think first mover advantages can cause rational bubbles, that is, bubbles in which each individual agent has a private incentive to buy into the bubble. In the same way a first mover advantage has the potential to create rational panic.

Given that rational panic is probably extremely rate in housing, I don't think the past will be a good guide for the future.

Home Price Decline Will Be Different This Time

2007-12-28T14:24:00.000-05:00

Lots of people have been comparing the national experience today with Los Angeles in the 1980s. Overall prices are inflated roughly the same amount and so the same decline is expected. There are a few reasons why I expect the price collapse to be more rapid and further.

1) The supply of homes increased rapidly during the boom yet the supply of potential homeowners is now falling. I believe that the core driver of the worst parts of the housing boom was a dramatic increase in the number of potential homeowners, created by declines in lending standards. As lending standards rise the number of homeowners will fall off rapidly.

2) The best advice that I could give to someone who is underwater right now and in non-recourse state is to walk away from your home. Take the hit now and start rebuilding your credit.

3) The best advice that I could give to someone who still has equity in a bubble area is to sell. Sell now. Things will only get worse in real terms. You are losing equity when you could be earning interest. Worse yet if illness, job loss or family emergency force you to sell in a hurry then you could loose dramatically more.

In short if you live in a bubble region the only reason to stay in your home right now is because you love your home. A lot. Otherwise it makes sense to get out before everyone else does.

Walk Away Nation

2007-12-18T14:58:00.000-05:00

Suppose, housing price to income ratio fall back to their historic norms. What are the worst consquences of massive declines in home equity.

My fear is that looking at years of being underwater and the likely prospect of having to move for family or job reasons some time in the next 7 years, that potentially hundreds of thousands if not more than a million Alt-A and perhaps even Prime borrowers will walk away from their homes.

We may reach point where walking away is the financially prudent thing for these people to do, not to mention the least painful in the short term. They become subprime borrowers for seven years but they we likely to be forced into selling the house for less than they owed within seven years anyway. Yet, in this case they get to move from what is bone crushing monthly mortgage payment to a much more reasonable monthly rent payment.

There may be some sense of embarrassment for many middle class borrowers to walk away from their homes and become renters but its the type of phenomenon that could become rapidly more popular once the first, most desperate home owners do it with few consquences.

In this case we are looking at a rapidly accelerating rate of foreclosures and perhaps a housing bust that begins to feed on itself and even overshoots the long run equilibrium by a substantial amount. How possible is this scenario? I don't know but it worries me.

Fed Statements Coming Back To Haunt Them?

2007-12-15T17:59:00.000-05:00

Repeatedly your blogger suggested that the Fed's credibility might take a blow during this financial crisis, without more aggressive efforts to manage market expectations.

I suggested that they hold in Oct, but signal high levels of responsiveness. That would have paved the way for a "shock and awe" 50 bps cut in December with a similar signal that the Fed is prepared to move rapidly. If they held in Oct, it is unlikely that the market would have been expecting 75 bps.

When they disappointed the markets in Decemeber they should have made mention to the strong GDP numbers in Q3. Let the market know that they see the future but we are in fact coming out of a rapid expansion and the Fed has to be sensitive to that.

Instead we have had a series of confusing statements and moves.

I do not envy the FOMC, Bernanke in particular. They are facing what may be the toughest challenge since the Great Depression. However, I do think that now is not the time to experiment with transparency.

Now is the time to offer statements that will serve to boost market confindence.

Now is the time to say that we are prepared to act rapidly when bad data comes in. Remind the market that the Fed takes employment and output to be the variables of interest, not asset values. However, as threats to employment and output materialize there will be a strong and vigilant response.

We can probably expect data that supports, what everyone believes to be true by mid January, thus implying that the Fed will move strongly in Jan and March to relieve stress to the real economy.

By the bye Nouril Robini is starting to convince me. More one that later.

Was There A Housing Bubble . .

2007-12-13T12:45:00.000-05:00

or a simply a credit bubble.

This may seem like a widly pedantic inquiry. What difference, if one even exists between the two, does it make whether there was a housing bubble or just a "credit" bubble? Prices are falling and that is obvious to anyone.

I do think it makes a bit of difference, though, in thinking about how this whole thing is likely to unfold and how to prevent it again.

Some people lay the blame for this crisis at the feet of Alan Greenspan and his failure to diffuse what was obviously a growing problem. The question for me is - from a macro perspective how obvious was it?

My own take is that the current crisis has most of its seed in the structured debt boom. Housing prices started to rise early in the decade from easy money and a decline in world wide long term interest rates. To the extent that this was the whole story we wouldn't have that serious of a problem on our hands.

Tightening monetary policy would have slowed down the rise in housing prices and we probably would have been able to pull of a soft landing. The problem is that at exactly the time monetary policy was tightening, credit standards were loosening, big time.

There was a sense, ill-placed as it may have been, that risk could be managed with far greater efficiency than ever before. And managing risk is terribly important. Had structured debt lived up to its hype it would have meant a revolutionary change for millions of Americans. It would have meant the opening of opportunities, the forgiveness of pass indiscretion and new chances which would lead to an eventual unleashing of entrepreneurial ingenuity. That, however, was not to pass.

So it turns out that people have fewer opportunities and banks are less willing to overlook imprudence. Thus, the dream home and dream opportunities that would have been yours, cannot be. This is real and it is a loss.

That's important, because it means that the bursting of this bubble is not as William Buiter suggests, a zero-sum game. We are not simply transfering income from current homeowners back to future homeowners. We slashing the opportunity sets of millions of current and future homeowners a like. Such an adjustment will be inevitably painful in the short term and I am not sure there is effective means for preventing something of the sort from happening again.

Inequality and Growth

2007-12-12T12:09:00.000-05:00

Quick post to get feedback on an idea.

I am beginning to think that inequality, in and of itself maybe an important component in at least the level of economic activity if not the rate of growth.

Why?

Well, traditional economic theory is based on the idea that people either work or not. If they work they get the prevailing wage. Higher wage can potentially encourage people to work more but even this is controversial since higher wage people don't "need" to work as much.

The thing is work is not work is not work. That is, the same person doing two different jobs could enjoy radical differences in productivity and hence income.

For example, it is not uncommon for an investment banker to be paid on the order of $500 an hour. Unless we think that the investment bank is in the business of giving away profits we have to concede that she is then producing at least $500 in value for the firm.

Suppose that same women were to become a cashier at the local dollar store. Now, no doubt she will be a great cashier. She will probably be faster and make fewer errors than the typical cashier but how productive could she be really? Could she produce ten dollars an hour, maybe at the outside fifteen dollars an hour worth of economic product.

Lets say she produces ten dollars an hour. Then the choice of this young woman to become a cashier rather than an investment banker will cost the economy $490 per hour of output. That's the same as if 49 cashiers had become unemployed.

Therefore, it much more important that we get this young woman to work in the correct field than it is that we get her to work at all.

Getting her to work in the right field doesn't depend so much on what the average wage is, or what the average tax rate is for that matter. It depends on the inequality in after tax wages between fields.

One thing that is striking about Europe is the intellectualism of the working class. Waiters on Champs-Elysees are able to and interested in discussing all manner of geopolitical issues. Socialist tend to applaud this as a mark of France's egalitarian nature. Even the wait staff are literate members of the body politic.

Yet, I am struck by the economic waste. If this person is both capable of and interested in geopolitics then they should be assisting the world in geopolitical decisions, not serving baguettes.

If it turns out that we can both educate and interest everyone in geopolitics, finance and the like, then no one should be employed as a waiter. After all, its not that difficult to grab your own baguette.

The Height Tax Properly Understood

2007-12-12T11:47:00.000-05:00

Greg's height tax is receiving some renewed attention. When originally proposed I objected to the tax on the grounds that if a part of the redistribution schedule were based solely on height it could have the unintended consquences of transferring money from a poor tall person to a wealthy shorter person.

Greg responded by email that there is no reason to tax the poor tall or give payments to the wealthy short. The tax could be non-linear.

Now, such a tax is still somewhat disturbing to my sentiment Yet, I've come to believe that this is based on the inability of my moral compass to digest non-linearity. That is, when thinking about the tax it is difficult for me to intuit the effects of a redistribution principle that depends simultaneously on two values potentially moving in opposite directions.

So how about this. Suppose using God's Current Population Survey (by that I mean one that is all knowing and completely infallible) we are able to determine the individuals who achieved success because they were tall and those that were denied it because they were short. We can also effortlessly transfer a portion of income from the lucky tall to the unlucky short. Would it increase or decrease equality to do so?

In other words, let's forget about the fact that Greg's paper depends on correlations, non-linear tax systems and economic approximations. Let's pretend that we know for a fact that some people have gained benefits solely because of their height and others have incurred costs. Would it then still be unjust to redistribute.

My gut says no, and this makes me believe that sentimental problem with the tax is not due to the outcome but the opacity of the method. The tax doesn't strike as moral because it's so darn morally confusing.

However, as economists we shouldn't let that stop us. The minimum wage doesn't strike most people as being unjust to the poor but careful analysis reveals that it often is. Likewise, the height tax doesn't strike us as a just way redistribute, but if we are willing to imagine a simpler redistribution system which accomplishes the same goal we see that such a system can improve justice.

Fed Cuts - Very Dovish Statement

2007-12-11T14:26:00.000-05:00

The real statement below, with commentary in bold italics

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/4 percent. Widely expected

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Starting with the outlook for growth. Not even recognizing the strong numbers from Q3. This is very dovish in my estimation. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time. Almost as if they are saying we actively working to stop what is an imminent recession.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.I wouldn't read too much into this. Failure to mention commodity prices in this market would be dereliction.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. I expected this at the top of the statement.The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. No explicit bias, but one has to assume that we are in a cutting cycle based on the language at the top.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; and Kevin M. Warsh. Voting against was Eric S. Rosengren, who preferred to lower the target for the federal funds rate by 50 basis points at this meeting. Wow! This is what caught my attention. No votes, not even Hoenig, to hold and a single preference for 50 bps.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 4-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, and St. Louis.

I am surprised by the softening of business and consumer spending language. I am surprised at no mention of Q3 numbers. I am surprised that no one voted to hold.

My best guess is this is a way of saying. We see a recession coming. We are working to stop it, but there remains a chance we could be wrong.

One Amazing Meme

2007-12-11T12:42:00.000-05:00

Via Mark Thoma

It is truly amazing that right now everyone in the country is deferring to Paulson and the heads of Countrywide, JPMorgan, Bank of America and others as the best group to work out a solution to this problem. No one is talking about the fact that these people created the problem and profited to the tune of hundreds of billions of dollars from it.

One of the most resilient memes in the western (if not human) conscious is that of the ever profiting powers that be. Its one thing to argue that Countrywide, Citigroup and others created the subprime mess, its another to think that they are profiting from it.

Since, when is facing a 10 Billion dollar write down and widespread rumors of bankruptcy profiting to the tune of hundreds of billions of dollars.

25 bps

2007-12-11T10:32:00.000-05:00

I would cut 25 bps and and here is a quick not well edited sample statement:

The Federal Open Market Committee decided to lower its interest rate target to 4-1/4 percent.

Recent data suggest that economic growth has been solid and that employment growth remains strong. However, since the committee's last scheduled meeting conditions in financial markets have deteriorated, approaching levels present this summer. In addition, the ongoing correction in the housing market and the associated disruptions in the market for subprime mortgage backed securities threatens the outlook for growth.

Core inflation has continued to moderate as expected though commodity prices have remained elevated and the committee judges that some risks to inflation remain.

While risks to both inflation and output remain the committees predominate concern is that further weakness in financial markets will lower the outlook for growth. While today's action reduces the risk for further financial deterioration the committee will continue to evaluate data as it becomes available.

In a related action the Board of Governors unanimously approved a 25 basis point decrease in the discount rate.

The language here is meant to give room for another move in the discount rate in late December or early January should things fall off a cliff. The worry is that the Fed needs some tool to calm the market if and when things start going bad without spooking them because of unexpected Fed action.

With this we can set up a one-two punch, 25 bps here and a possible cut at the discount window around the new year. The hope is that will get things functioning back to normal. Its going to take some time for exports to come to the rescue but if we can keep the bottom from falling out until next summer I think we have reasonable shot at making this a mild recession.

The worry of course is with some securities going from AAA to worthless (yes, I don't mean junk or even default I mean nothing, nada, not a dime, no recovery whatsoever) in less than a year its hard to see how there aren't some significant freeze up in credit markets.

Where I Spit Out My Evening Tea

2007-12-09T22:26:00.000-05:00

I am sure most of you have seen this but are you kidding me!

I've never said all tax cuts pay for themselves. I never even said Reagan's tax cuts would pay for themselves."
Arthur Laffer

HT Mankiw

Here We Go Again

2007-12-09T22:02:00.000-05:00

Looks like UBS may deliever some more write downs on subprime. Will more banks and brokers fess up on fourth quarter before Christmas? If so the probability of a Santa Claus rally is slim.

Hat Tip to Caluculated Risk (the best real estate blog by far)

By the bye I am looking for 25bps from the Fed this week, but who isn't. I'll try to get in my mock statement before tomorrow is up. End of the calendar year is a busy time in the ivory tower.

Oct All Over Again

2007-12-06T12:47:00.000-05:00

Mike asks if the ADP report reduces the probability of a cut.

Well, the word about the blogosphere is that ADP has some issues with its November forecast. I have not looked into to it, but it seems Nov is always an outlier. The question is what number we get on Friday.

Another issue is the market response. I had been thinking of a post on the "Long Bear Case"; the possibility that we could see an inflation adjusted decline in US equity values well into the next decade. The sell off in the market prompted me not to hold off, so as not to be overly alarmist.

However, I think it is equally important to think about whats happening now. The current run up feels like Oct all over again. Then talk was ripe that we had priced in this whole subprime mess and could get on with the business of going upward.

I think this is unlikely. My guess is that things are likely to get worse. Significantly worse. There will be more write downs in the forth quarter and consumer spending will start to sting in early to mid 2008.

The decline in housing prices will steadily weaken the consumer because most of the pain comes through credit constraints. That is households stop spending because the bank stops lending money, not because they simply "feel" poorer.

Indeed, the "smart" household is loading up their HELOC now. Money is only likely to become harder to come buy and who really thinks the prime rate is headed up from here? If you want to buy it, you'd better buy it now. That's what the mortgage brokers are going to be selling and they are correct.

To me this means that consumer weakness is going to become much more pronounced next year than it is this year.

Losses = Lessons Learned?

2007-11-28T10:24:00.000-05:00

In Oct. I was concerned that a rate cut could lead to an erosion in Fed credibility. The way I saw it the Fed had to options: hold firm and signal more easing or cut and signal that the easing cycle was over. I prefered the former, the Fed chose the later.

Now, it seems that their decision may be coming back to haunt them. As many have pointed out the situation has detoriated and there is strong reason to ease again in December. I tend to support antoher quarter point cut at this point.

However, what does it say about Fed credibility and foresight that just weeks ago they signaled that the cycle was ending and now it may be begining anew?

On the positive side, though, massive losses by the banks and brokers have loosened some of the concern about moral hazard. With record right downs it is hard to argue that the financial markets have not been forced to account for the excess of the past five years. This is good news for those hoping for more cuts.

Bear Hawk(ish)

2007-11-16T11:08:00.000-05:00

I find myself in a unique position among econo-commentators. On the one hand I am bearish about the medium term prospects for the US domestic economy. On the other I am not yet convinced that this demands large cuts in the funds rate.

First, the bear case. It is difficult to imagine a scenario under which domestic consumption does not experience a significant slowdown over the next 18 months. To wax nerdy for a moment the structured finance revolution that gave birth to the housing boom was akin to a massive technological advance for the US, or so we thought.

It seemed as if considerable amounts of risk could be redistributed and managed for much lower costs than in the past. Risk drives a wedge between the interest rate that borrowers are willing and able to pay and the rate that lenders are willing to accept. A reduction in risk means that there are a whole host of new transactions that are now possible.

Like the internet bubble, however, the credit bubble was based on over optimistic assumptions about the power of this technology. Incidentally, the credit bubble was also sparked by large increases in computing power, but that is another story.

The upshot is that even if consumers feel no wealth or collateral effects from housing their borrowing capacity will be reduced.

In addition, we have a number of traditional forces at work. Banks are seeing huge losses on their balance sheets which will lead them to reduce lending. Consumers are facing a decline in home equity which will reduce the collateral they have to post against loans. And, finally people will at least feel poorer as a result of declining housing prices. All of these forces work against consumer spending.

So in the face of all of this why am I not advocating massive rate cuts? Part of the problem is Fed credibility. We experienced a good bit of pain in the early 80s and 90s to get the inflation rate down. The willingness of the Fed to risk those episodes did a lot to promote credibility on the inflation front. I would hate to see all go down the drain now.

Relatedly there is the issue of growth in the rest of the world. It is that growth that is creating inflation pressures, and it is also that growth which has the potential to provide some support to the US economy.

Net exports are surging and will probably continue to do so as domestic consumption slows, foreign consumption rises and the dollar shrinks. Whether or not net exports can prevent the US from sliding into recession is an open question. I tend to doubt it, but the jury is not in yet.

What does occur to me, however, is that by charting a relatively steady course the Fed will allow the trade deficit to unwind in an orderly fashion. Cutting rates aggressively generates a lot of uncertainty.

On the one hand basic theory predicts that a lower funds rate would depress the dollar further and push up net exports. On the other hand, easier money could alleviate consumer pressures, increase US domestic profits and lift the dollar on rising equity values.

If we experience the first case we risk seeing the dollar fall off a cliff. If we experience the second case we suspend the dollar ever higher against fundamentals. The steady but seemingly controlled decline we are experiencing now seems to be working and I don't see why we would want to mess with that.

We keep domestic inflation very low, we let rising commodity and import prices play themselves out. We allow the trade deficit to correct itself through lower US consumption, a weaker dollar and growth overseas.

The result will be a painful course correction for the US economy, but a much needed one that will put the global economy on a more sound footing.

Is Wal-Mart Driving the Trade Deficit

2007-11-13T12:38:00.000-05:00

KNZN asks why Europe doesn't have a growing trade deficit.

After all, the euro is surging against the Asian currencies and Asian manufacturing is only getting more productive. If exchange rates and productivity are central to explaining the Asian export story then why isn't Europe more in the hole.

A theory, for which I have as of yet developed no empirical support, is that Asian productivity is not at the heart of this story, nor exchange rates.

The key is US productivity - US retail productivity in particular.

See, economists not only fall into the trap of immaculate transfer, the notion trade deficit magically go away when national savings exceeds domestic investment, but also the trap of immaculate delivery.

In other words, we assume that all that needs to happen is for foreign goods to be produced relatively cheaper than domestic goods and then they will magically be consumed. The problem is that the goods have to get from the foreign country to our living rooms. Somewhere in that process comes retailing.

Retailing is possibly important because we have seen massive increases in productivity over the last 15 years in retailing, with Wal-mart leading the way.

Lets assume the following example:

Suppose that originally an America toy costs roughly $5 to make and $5 to distribute and retail for a total of $10.

Now, you could get a Chinese toy stateside for $1. That means it retails for $6. However, its a piece of crap and it costs about 60% of the the American toy. With the two relatively close in price and both somewhat expensive you might as well opt for the American toy.

Enter Wal-Mart. Efficiencies in distribution and inventory management cause retailing margins collapse so that the it costs only a $1.20 to distribute and sell the toy (gross margin on the American toy falling from 50% to 20%) .

The American toy now retails for $6.20, which is a great deal. Yet, the Chinese toy retails for $2.20. It may be crap but at $2.20 why not just get it!

In this case whats happening is not that Chinese imports are getting cheaper themselves but they are getting relatively cheaper because retailing costs are falling. Just like the well known result that rising excise taxes shift consumption towards more expensive items, falling retail costs will shift consumption towards cheaper items.

What does this have to do with Europe? Well Wal-Mart and big box retailers have been considerably less successful there.

Why up is really down

2007-11-01T10:10:00.000-05:00

A few people are questioning whether its strange that surging oil price could led to falling domestic inflation?

It is a little strange at first but the answer is simple.

From a consumers point of view gasoline prices were pretty flat. So the gasoline price change is 0%.

We get gasoline by refining foreign oil here in the United States. So

Foreign Oil + Domestic Refining = Gasoline

However oil prices went up 10%. And gasoline prices stayed the same, So

10% + X = 0% =>

X = -10%

Or domestic refining prices fell by the equvialent of a 10% increase in the price of oil.

That has to be true or else the increasing price of oil would have caused increasing gasoline prices. If something is going up and the total is staying fixed then something else must be falling. That something else is domestic refining.

Now what does this mean for GDP?

Not much. The higher oil prices made our domestic refining seem more efficient which would tend to boost GDP. Yet, the higher oil prices also lowered our net exports which decreases GDP. The two effects cancel out.

Fed Cuts - Bond Rates Gap Higher

2007-10-31T13:24:00.000-05:00

The Fed chose to cut and the immediate response is a sell off in the long bond markets. With the GDP and ADP reports where they were my guess is this cut dealt a substantial blow to the FEDs inflation fighting credibility and that ironically those looking to refinance into 30 year mortgages my find it more difficult.

A Cut on These Numbers????

2007-10-31T08:41:00.000-05:00

My fellow bloggers have repeatedly said that the looming recession is "worse than expected." I am not sure what tea leaves they are reading.

Perhaps, they mean that housing is collapsing faster than estimates? But, we knew that would happen didn't we? All forecasting models assume that the future will be like the past. Yet, no person seriously thought this future would be like any past that we've seen. Underperforming the models was to be expected.

What wasn't expected was the increase in new jobs, surging GDP and consumers with their credit cards out in force.

A cut on these numbers is downright irresponsible and could ironically make long term rates go up on justifiable inflation fears.

No cut today. Perhaps, no cut in December. We need to see some slack first.

Is the Core a Ruse?

2007-10-30T10:54:00.000-05:00

Barry Rithotlz says that the FED chooses to use the core so that it can ignore the fact that inflation has been anything but contained over the last decade. Food and Energy is where the real inflation is but the FED has blinders on.

To look deeper at that theory I have both the CPI Core and Headline (top panel) and the PCE Deflator Core and Headline since 1980 when Paul Volker took the helm and the FED got serious about inflation.

There are at least three things to note.

1) The core, especially in the PCE series, seems to behave like a core, in that is cuts through the ups a down of the headline rate.

2) There were periods in the 1980s when the core was consistently above headline inflation.

3) The real aberration occurs around about 2004-2005. Judging from the general behavior you would expect the headline to dive below the core again. But it doesn't, it jumps up and continues its see-saw pattern at a higher level.

That coincides with both Katrina and the general realization that there was going to be no easy way out of Iraq. Both of those events tightened the market for energy and we have experienced a sustained increase in the price of energy that is not clearly supported by market fundamentals.

This seems like precisely the kind of thing that the FED should not be jumping at.

Agflation not Oil Prices

2007-10-30T09:32:00.000-05:00

More of my colleagues are agreeing with me that no cut would be the right move, even if they think the FED might cave to market pressure this time.

Many, however, mention rising oil prices as a concern. I don't see that. First, as far as I can tell crude is in a slight bubble. Crack spreads are declining and some of the smartest players are becoming at a minimum less long crude and probably starting to take out short positions. At a minimum crude's upward swing is limited by Saudi fears of letting the alternative energy genie out of her bottle. There is reason to believe that basic R&D is the big stumbling block here and $100 crude will interest a lot of alternative energy venture capitalists.

Agricultural prices are a different beast. Not to put too fine of a point on it, but remember when you were supposed to finish your dinner because of all those starving kids in China? Well they're not starving any more. They are out bidding you.

Couple that with the demand for bio-fuels, increased transportation costs and climatic instability and I see a recipe for sustained increases in food costs over the coming 2 - 5 years. While these forces are not monetary in nature it is hard to refer to a sustained increase in the price of a basket of goods as something other than inflation.

The FED will have to respond to this secular trend in a effort to manage inflation expectations even if they know that the fundamentals are ultimately transitory.

Stand Pat

2007-10-27T12:43:00.000-05:00

Not much time recently. I wanted, however, to make a note of my thoughts on FED policy ahead of next weeks meeting. As I mentioned before I have been consistently more hawkish than the Bernanke or Greenspan Feds.

Last time I called for 50 bps, with another 25 in Oct based on where the data was trending.

The data did not, however, unfold as negatively as I had guessed. My stance would be to hold on Oct. and wait for the data to cut again, possibly another 50 bps in December.

Part of my reasoning is that we do not in fact have enough data to justify a cut, and partly because the thinking on Wall Street has evolved into believing there is a FED put. While balancing inflation expectations and unemployment should always be the FEDs predominant concern, efforts should be taken to relieve the moral hazard posed by presumptions that the FED is "pro-stock market." This provides the perfect opportunity to accomplish both goals.

I would say something to the effect of:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 4-3/4 percent.

While trends in the consumer real estate remain negative and the outlook for overall growth is slightly below potential, financial markets have stabilized considerably since the summer.

Recent readings on inflation have been promising and core inflation has moderated as expected. However, headline inflation readings remain elevated and there are concerns that secular trends in agricultural prices will begin to raise inflation expectations.

While risks to both inflation and output remain, the committee's predominant concern is that an acceleration in the housing correction could contribute to protracted weakness in US growth rates. The committee will monitor data as it comes in and is prepared to act, rapidly if necessary, in response to significant deterioration in output and employment.

Is This A Picture of The Bank Lending Channel

2007-10-18T11:32:00.002-05:00

One line of reasoning suggests that business cycles are really credit worthiness cycles. That in good times ever more shaky borrowers are allowed access to credit. At some point the credit bubble pops, lending standards rise dramatically and the economy slides into recession.

Looking at the above picture on subprime delinquencies are we seeing just that. A sharp decline in delquinacies in 2003 as the recovery took hold and then a big increase in 2006 -2007 as the economy begins to slide back towards recession.

Of course the other explanation is that economic conditions are driving the delinquencies but then how do you explain that they seem to lead the job market? For example, jobs were still soft in 2003 when delinquencies were low and the market is just now softening though delinquencies have risen.

What Good is Mechanism Design

2007-10-18T11:32:00.001-05:00

Arnold Kling and Tyler Cowen pooh-pooh the work that won the latest Nobel Prize in Economics. I tend to stand more in line with Alex Tabarrok who credits mechanism design with inducing a greater appreciation of markets.

More broadly I would say that Incentive Compatibility Constraints (ICC) are the theoretical nail in the coffin for socialism. When I talk with serious socialists, and yes they do exists, ICC is always the backbone of my arguement.

Yes, the market does badly I say - but the question is whether it is even theoretically possible to do better. The sophisticated socialists tends to believe that current incarnations are a bogus and that are more through, scientifically designed socialism would be more successful.

Incentive compatibility constraints show why that it is unlikely.

They also help us out of conspiracy theory traps and frightening pop fiction. The problem I always say with 1984 is that it completely ignores any semblance of incentive compatibility. In what sense is the politics of 1984 consistent with a law enforcement structure that pursues its own personal interests? Who enforces the law upon the enforcers? And the who enforces the law upon them and why don't they all just collude?

Lastly, however, ICC gives a window of insight into dictatorship and helps us think through why claims that Iraqi people must uniformly welcome the US as liberators. If they all hated Saddam then by what means was Saddam maintaining power. All successful power structures must be incentive compatible. There must be some reason why it is not in the best interests of the generals to lead a coup.

That reason is going to be key in establishing a successful government.

The Malthusian Regime

2007-10-08T13:46:00.001-05:00

I am late to a debate going on between Bryan Caplan and Greg Clark over the Malthusian Regime. Bryan essentially takes the stance that decreases in population should not be seen as key in raising the standard of living. Presumably because of increasing returns to scale in the production of technology.

However, it seems straight forward to me that that increasing returns in one factor of production are temporarily outweighed by decreasing returns in another. Overtime as technology accumulates the overall functional form moves from decreasing to increasing returns. That shift represents the transition from the malthusian regime to the modern epoch.

Below is a simple numerical example of this type of thing. Income is a constant returns to scale function in technology(we are thinking of ever more advanced capital), labor, and land.

Technology does not depreciate and its accumulation rate is increasing in the total population level. The population grows a steady 2%. Land is fixed.

At first income per capita is decreasing because land is fixed. However, eventually enough technology accumulates that its increasing returns production dominates the fixed quantity of land.

One has to remember, however, that population effects the growth rate of technology, not its level and that the underlying capital accumulation is driven by income, perhaps even income per capita if you consider minimum consumption constraints.

Therefore, it is possible that far from delaying the industrial revolution the black death brought on the industrial revolution by increasing per capita income at a high level of technology.

Basically what helps in this model is to build up a big population to increase the technology level and then to wipe a bunch of them out to increase income per capita. The historically unusual combination of technology and wealth will rocket you forward.

How Good was the Sep NFP Release

2007-10-08T08:56:00.001-05:00

On the one hand July was revised up 25K, August up 93K and Sept came in at 110K for a total of 228K more jobs than we would have thought the day before. On the other hand the March 2007 Benchmark revision slashed 257K jobs - leaving the overall level of jobs 17K less than we would have thought.

On net it is roughly a wash.

However, I would suggest that the sizable downward benchmark revision is not the best sign. The BLS methodology produces considerable inertia in the estimates. The birth death model creates or destroys jobs based on how well the monthly data performed in relation the benchmark last time around.

The upshot is that the NFP report will tend to miss turning points. Indeed, if the turning points are close together in time the the methodology should significatly amplify the peaks and troughs.

If the benchmark March 2007 was already revising jobs downward then that implies to me that the turning point was likely sometime before that. Thus all of our estimates until the new benchmarking comes into effect will be overshoots.

Moreover, there is reason to think the economy has weakened since
March 2007 and that our overshoots are actually accelerating. It will be interesting to see how the unemployment rate fairs by the beginning of 2008.

Dead Wrong

2007-10-05T14:10:00.000-05:00

Both September NFP and the August revision were well off my predictions. The overall benchmark adjustments were in line. That is, job growth was significantly weaker this year than reported. As a result the BLS data is now roughly in line with ADP.

My confidence in a Oct rate cut has dropped significantly. More later.

NFP to be lower than Expected - BLS is playing catch-up

2007-10-04T11:39:00.000-05:00

My non-model guess is 50K new jobs created.

See Calculated Risk on a good chart showing BLS vs ADP estimates of private employment. The ADP report shows less volitionality and there is reason to believe that BLS has overshot the peak. To date BLS is reporting 200K more private jobs than ADP. I expect that the BLS report will be playing catch up in the coming months.

Whose Afriad of the Falling Dollar

2007-09-28T18:52:00.000-05:00

There is plenty of hang wringing over what a weaker dollar portends for the US. Will it impoverish us? Reduce us to third-world status? End the US growth machine.

I am perhaps alone in thinking its one of the best things that could happen to the US. The big problem for America going forward is not growth. Its not entitlement spending. As much as I bemoan it, its not even directly our poor K12 educational system.

Its that an America with a strong university system, a strong financial infrastructure and a strong dollar has little use for strong backs. In the long run that's a good thing, but in the long run we are all dead.

Today, its a heartbreaker.

Its heartbreaking to see Americans who just don't have the financial or intellectual capital to compete in modern America fall behind.

Its also scary.

Its scary to see protectionist sentiment rise and the spectre of class warfare haunt Capitol Hill.

A falling dollar could change that. It could make American industry competitive. It will unwind the growing current account deficit - a process that while not without pain is also not without merit. It would not be such a bad thing for those of us who have done well to cut back in favor of gains among the working class.

And, it would be a great thing for that to happen through natural market mechanisms than government regulation or ill fated attempts at moral suasion.

Payroll Tax Hike

2007-09-27T09:02:00.001-05:00

Greg discusses Obama and Clinton's proposal to eliminate the cap on Payroll taxes.

Of the many ways to raise substantial revenue I view this as among the best. My hunch is that hiking the payroll tax will have limited negative effects for several reasons

1) Upper income wages are mostly economic rent. Individuals who make more than 90K a year are primarily living off of the fact that they are significantly more talented than lower income people and have a preference for high productivity jobs¹. These factors are largely fixed by a combination of genetics and culture and unlikely to be influenced by marginal tax rates.

2) The possibility for tax avoidance or evasion is lower with payroll taxes than the income tax. There are few exemption and no deductions making tax avoidance really difficult with the payroll tax. Moreover, a business would have to be complicit to engage in tax evasion. Both of these factors make the payroll tax more efficient.

3) The payroll tax treats workers in the same household independently. Payroll tax exemptions for one spouse don't affect the payroll tax owed by the other spouse. For example, raising the husbands payroll tax makes the wife more likely to work, not less. The income tax probably does the opposite in high income families.

4) People hate the payroll tax. Karl's Law states that given equal size tax bases the economic destructiveness of a tax is inversely proportional to how much people hate it. That is, people hate taxes that they can't wiggle their way out of. Those are precisely the most efficient taxes.

I chose teaching and practicing economics over teaching and practicing painting not because the significant pay differential but because I prefer interpreting abstract art rather than creating it.

Sticky Price, Sticky Homeowners or Sticky Mortgages

2007-09-25T13:57:00.000-05:00

Ed Leamer says that Housing IS the Business cycle. As I mentioned before I was struck by the comment in paper, the name and author of which escapes me, that "contracts could be indexed for inflation for instance mortgages could have variable rates"

After all, most mortgages didn't have variables rates and at the time and most people considered variable rate imprudent. I think most people still consider a One Year ARM imprudent and thats really what the author was getting at. So if housing IS the business cycle then perhaps, housing contracts or more specifically mortgage loans ARE the source of the monetary lever.

Now how does this account for the passage by Hume often quoted by Mankiw that increases in the supply of money first quick the work of every man and only later lead to a general increase in prices. The implication of that passage is that the effects of the money supply on the economy have operated the same way for at least four hundred years. Was mortgage stickiness a problem in 18th century England? Perhaps, there were other important nominal contract, bonds or agreements.

Now suppose that the source of the business cycle is owner occupied housing and long term mortgage loans (think of it as time-to-build communities). Then one question is why the devil is it such a bad idea to get variable rate loans? The empirical evidence suggests that is. I know that despite going way out on a limb and leveraging myself to high heaven, I have avoided them. Yet, I am not sure why. It has something to do with not being able to predict my expenses but why should that matter this much? Is it some form of extreme loss aversion? Is it as simple as neighbor capital? The longer I live somewhere the more painful it is for me to liquidate my holdings. I don't know.

Smart is as Smart Prefers

2007-09-14T11:54:00.000-05:00

Picking up on another Cowen post I am sticking a flag in the sand and declaring my hypothesis that the genetic component of intelligence is preference. That is, smart people are people who like intellectually stimulating experiences. My guess is that they are more sensitive to the pleasure chemical released when successfully solving a hard problem. Thus they solve more hard problems.

In the process they build thinking strategies and increase neural efficiency. The result is that they are much better at performing mental tasks.

Ala Judith Harris I take the position of zero direct enzymatic influence. That is, there is no enzyme (remember gene's operate through enzymes) that produces more efficient mental processing without a change in environmental stimulus.

For those who have trouble seeing how this might work consider this: Obesity has a strong genetic component. Obesity like IQ has been rising over time. However, does anyone believe that obesity is not completely determined by your food consumption and exercise patterns? Genes can modify that function, in particular they can modify your equilibrium levels of food consumption but they cannot act outside of the environmental regime.

Four Biases

2007-09-11T12:45:00.000-05:00

Bryan Caplan talks about four potential biases in popular thinking about economics. He has written a book on the subject that I embarrassingly have not read. However, I have read journal articles and blog posts by Bryan, so I think I have the gist of his point.

However, I am begining to wonder whether or not the "baises" are simply misstatements of real economic problems.

Anti-Foreign Bias: This is the easiest to see. Economists are found of equating differences between countries to differences between households, towns or states. However, the immediate problem is that nearly everyone would choose some Kaldor-Hicks inferior position if it shifted the distribution of goods towards a member of their household. Many people would even sacrifice their own consumption to increase that of household members. Put simply, the closer you are to someone geographically the more likely you are to be an input to their utility function.

In addition there are local economies of scale. Otherwise no one would be paying Manhattan rent. It benefits you to live near other successful people. Moreover, since this is the case it is reasonable to conclude that foreigners will attempt to collude against you so that there locality will grow at the expense of yours. Fighting over attracting residents is typically a zero sum game. Even more so if we are trying to attract the most genetically gifted residents.

Anti-Market BiasI think this is probably an expression of concern over asymmetrical information and cognition costs in general. People are afraid of being screwed in the market, and they should be. Not understanding how the market works causes lots of problems for people. Economists are not afraid because they have lots of information. It seems rational to be more concerned about asymmetric information problems when your information set is quite small.

Make Work Bias I won't go into detail but if you talk to people about this carefully it usually comes out that they are concerned about the growth of the money supply in response to economic shocks. They don't realize this is their concern but it is really what they are talking about. And they are right, if the money supply isn't managed there can be increases in unemployment from demand and productivity shocks.

Pessimistic Bias I think this is a symptom of rate of time preference inconsistency. Perhaps hyperbolic discounting. Most people's live are getting worse in that their opportunity cone, opportunity set over time, is shrinking because of consistently bad choices. Bad in the sense that people wish that they had not made them.

Yes, their opportunity set grows over time but at time T it is smaller than than it would have seemed looking into the future from T-1.

Modeling the Internal Princple-Agent problem

2007-09-11T09:18:00.000-05:00

Tyler Cowen asks why "Call me naive but . . . " works better than "I am not naive." After all both are intended as signals that the person is not naive. This works because it takes advantage of the fact that a person is not a unitary entity.

Most of the time we can act as if people have a single well defined objective function. Indeed, much of the time we can act as if households have a single well defined objective function.

However, there are times when this model breaks down. Households disagree internally and people have personal internal conflict.

For the sake of this model lets say there are two entities within each person. A purely internal manager and a communications agent.

The communication agent wants to be trusted. The internal manager wants to feel self confident. If the internal manager is indeed naive, then he will become upset at the communication agent's statement "Maybe I am naive" and potentially shut him down.

The communication agent will have to deal with balancing the threat of being shut down with his desire to be trusted. Making the statement "Maybe I am naive" signals to other agents that the threat of being shut down is low and therefore the internal manager is probably not naive.

I believe nternal principle-agent problems are part of why deceit is more difficult and less common than traditional models might suggest.

Hawk No More

2007-09-10T09:01:00.000-05:00

I tend to agree with KNZN's assertion that what is need is fast decisive action by the FED. Even as late as this spring I was a hawk, calling for increases in the funds rate by 25 -50 basis points. Now I am reversing course, looking for a 50 basis point cut now and a bias towards at least 25 more basis points if the September employment data is as bad as I expect.

Isn't this the kind of schizophrenic action that bankers are supposed to avoid?

The traditional approach says yes, but I am coming to believe that slow steady tightening with a tendency towards over-tightening and then dramatic easing might be the way to go.

Why?

Because the response pattern from monetary policy is humped shaped. We get real effects first, inflationary effects later. Moreover, the damage from recession is that people lose their jobs and can't pay their bill immediately. The damage from inflation occurs because the long term trend of prices becomes less certain.

Pumping loads liquidity into the economy as it tilts into recession has the potential to stop what is happening now and prevent the acute crises that comes from joblessness. On the contrary controlling the evolution of prices should be a much more gradual process that convinces financial entities that, whatever happens today, the value of long money is protected.

From a slightly nerdier prospective, the suboptimality of a recession occurs because liquidity constrains the equation of marginal cost and benefit. The suboptimality of inflation occurs because uncertainty drives a wedge between marginal cost and benefit. Setting the modal response towards over tightening combined with spikes of easing provides slack when constraints bind while keeping expected values in the target range.

Why NFP is even worse than it seems

2007-09-07T08:44:00.000-05:00

You probably know the BLS job creation estimate was negative for the first time in four years. In my on going debate* with Barry I maintain that there is nothing fishy about the way the BLS uses its Birth Death model. The error comes from the fact that the Births and Deaths are estimated by looking at how the model performed last year. When times are changing fast the BLS model is likely to miss that. It under estimated the strength of the labor market when job creation turned around in late 2002 and it is overestimating job creation now.

As I thought the June / July numbers wererevised downward. I wouldn't be surprised if July was revised downward again and if the August estimate dipped even further in coming months.

Upshot no conspiracy, no willful misreporting, but a very week labor market.

*Debate in the sense that Barry graciously takes time off from being a super blogger-pundit to answer my objections.

What's So Special about U6

2007-09-06T10:16:00.000-05:00

Barry Ritholtz repeats the popular line that "real unemployment" is much higher than headline unemployment.

U6 is indeed higher than U3. The problem is that value in unemployment stats comes from comparing different points in time and throughout time U6 has always been higher than U3.

When one says, if the "real unemployment rate" was 4.6 the labor market would be tight, you are using your familiarity with U3 to call 4.6 a tight market. Even in the heyday of the late 90s U6 was above 7%. If U6 was 4.6 today the FED would be talking about moving the funds rate upwards 50+ basis points per meeting.

The BLS has data on U6 going back to 1994. The gap between U6 and U3 is procyclical and as one might expect lower now than the average of the last 12 years and only slightly above the roaring 90s.

US Leads

2007-09-03T16:41:00.000-05:00

In a new productivity study (still searching for the study itself) reported by MSNBC and the Associated Press.

The US comes out on top in total production per worker and second in hourly productivity. Norway edges us in part because of oil revenues.

I have long been concerned about productivity statistics. Typically my attitude towards statistics is that they are ultimately just the mathematical product of several measurements and should be treated as such, no more, no less.

However, productivity is a bit different. It is the closest a statistic comes to answering our most important question: How effective is an economy in allowing people to achieve the most goals in our fundamentally limited time on earth.

Production per hour is important because hours are the stuff of life. The fewer we have to spend toiling to survive the more we have to devote to whatever makes surviving worthwhile.

So what about hourly productivity. Well one problem is that it doesn't count people who want to work but can't find a job. In particular we could raise our productivity just by forcing less productive workers out of the market. This theoretical possibility wouldn't be important if it weren't for the fact some popular policies do exactly that.

Expanding unions and raising the minimum wage can both raise hourly productivity, but they do so by forcing out the weaker members of the workforce. This doesn't seem like the type of activity we want to capture.

Yet, simply averaging in the unemployed isn't right either. After all, they are likely unemployed because they are less productive. Simply slotting them into the denominator would suggest that they are just as productive as the average working member of society.

So at this point I am at loss for the "right" statistic on such an important matter.

The Diversity Paradox?

2007-08-07T09:36:00.000-05:00

An Article in the Boston Globe highlights Robert Putnam’s research on diversity. The take home message is that diversity seems to lower social capital, yet increase creativity and possibly economic growth. This is labeled a diversity paradox.

However, it seems to me that there is no paradox at all, at least with respect to creativity. Diversity increases creativity because it lowers social capital.

A sketch of a model:

There are two levels of social goods: global and local.

Finding a cure for cancer is a global social good; building a children's center is a local social good.

People are compensated for the production of social goods through status.

Each ethnicity has a different preference ordering over local social goods.

In a mulit-ethnic community there are fewer people who prefer any one social good. Therefore, the status return is lower to producing local socials goods. The status return to global social goods is constant everywhere.

When communities become more diverse people substitute the production of local social goods for global social goods.

That is, it is more difficult to become famous and loved by all for being a civic leader so I tend to invest more time in becoming famous and loved by all through some national level accomplishment.

This might suggest that diversity itself is a public good but I am not sure. That is, it could be that homogenous communities are piggy-backing off of the global social goods produced by diverse communities.

Hat-tip Mankiw

Losses II

2007-08-06T11:13:00.000-05:00

Losses 0.9 Beta.

Something like this is probably going out.

What's Next

2007-08-03T12:37:00.000-05:00

The start from what I am working on now

A Contribution to the Theory of IQ and Economic Growth

This paper takes Garett Jones seriously. Forty years after Robert Solow’s classic article suggested that long run growth depends on increases in total factor productivity Jones and Schneider (2006) proclaim:

stylized facts related to IQ and productivity are ready and waiting for the theorist who seeks to explain a large part of the puzzle of cross-country productivity differences. Accordingly, persistent difference in national average IQ—regardless of their source—may play an important role in answering Prescott’s (1998) call for a theory of total factor productivity

In a series of papers Jones, twice with Schneider argues, that

1) IQ is one of, if not the most powerful predictor of economic growth

2) IQ is a proxy for and indeed may be the primary source of otherwise unobserved worker heterogeneity

3) IQ correlates heavily with a tendency towards cooperation

4) The effect of IQ is more powerful at the macroeconomic level than the microeconomic level

5) The effect of IQ on growth rates is persistent and likely associated with higher growth rates rather than higher steady states

6) The importance of IQ on economic growth has been increasing since at least the mid twentieth century

7) At least in a naive sense the growth does not appear to cause changes in IQ

My goal below is to provide a theory consistent with these facts.

Nice work if you can get it . . .

2007-08-03T09:19:00.000-05:00

The jobs report disappointed today at 92K vs. a consensus 130K. I believe this number is likely to be revised downward in the coming months because of the birth-death adjustment.

Each month the BLS has to estimate how many jobs were created in new companies and destroyed when old companies went out of business. The way it does this is by looking at how far its count was off a year ago.

That is, if last year the BLS counted 150K new jobs in July but then, after all new companies were firmly established, they went back and counted 170K new jobs they say that the birth-death adjustment needs to be 20K higher. In other words, last time they guessed 20K too few so this time they will add 20K to their baseline guess.

Here is the problem. Last time the housing market was surging and all sorts of upstart companies were coming on to cash in. Fly-by-night organizations that support builders, suppliers, etc.

Clearly those extra jobs aren't being created now and so the BLS is likely to be overly optimistic. By how much, I don't know. If there was a reliable way of fixing this problem then the BLS would use it. However, there is not and so we are left to readjust on our own.

Bottom line . . . job growth is slowing.

UPDATE: Commentors on Ritholz report that the Birth-Death adjustment for July is 26K new jobs. Typically, we find that around 50K are lost from companies' Birth/Death in July as kids get ready to go back to school, housing sales slow, etc. However, this time we got an estimated 26K created from Birth/Death. I strongly expect that to be revised downward.

Fertility and the IQ of Nations

2007-08-02T12:39:00.001-05:00

We have long known that economic growth was associated with decreasing family size. It appears the increases in IQ may also be associated with decreases in family size. The myriad of ways in which this trivariate correlation could be explained are tantalizing but for now I will leave you with the data itself.

P.S.

I can't help but mentioned that if low IQ caused larger families then we would expect IQs to decline over time. In fact they have been doing the opposite. What I wouldn't give for good measures of Chinese IQ before the 1-child policy.

Do Smart Guys Tell Better Jokes?

2007-07-26T12:32:00.000-05:00

In the wake of the recent blog brouhaha over IQ and the Wealth of Nations I have been thinking about the general connection between intelligence and income.

My interpretation is that many people find it natural to conclude that IQ causes macroeconomic growth because IQ appears to cause microeconomic success. High IQ people are richer people, on average.

While I am sure that many smart people are quick to assert that their intelligence is what got them where they are, are we so sure? Height is correlated with individual success. I willing to bet height is also correlated with economic growth. And, we know that there is a height “Flynn effect.” That is, people have been getting taller over time. Do we think height causes growth?

The height correlation is usually settled by noting that height is a general sign of health and fitness, thus the correlation with macroeconomic growth, and therefore tall people are more likely to be chosen as spouses of successful people. Rich men and women have a greater choice in spouse and they tend to choose taller ones. Therefore, height and the genetic or cultural traits that produce wealth are commingled.

Could the same thing be true with IQ? That is, are smarter people more likely to be chosen as spouses to the rich and powerful? Now one possibility is that intelligence is just out and out attractive. Some people may agree with that conjecture.

Another, however, is that intelligent people are more likely to land a successful spouse because they are more clever at the dating game. My pet theory is that the human brain evolved through sexual selection. It’s just too big and mostly useless to have come about any other way. Looking at the monstrous and dangerous thing sitting a top most people’s shoulders one cannot help but be reminded of the Irish Elk.

It wasn’t so much that we impressed each other with our big brains, but that those brains busied themselves with devious plots to ensnare the objects of our affections. Most of us are aware of the modal thought among men and I would reason a guess that the modal thought among women is the dissection of the thoughts and intentions of men.

It seems possible then that IQ may simply be commingled with the attributes that produce success. My guess is that those attributes have more to do with perspiration than inspiration.

Why Trade?

2007-07-26T09:21:00.000-05:00

So the common objection I have gotten to my draft both on and off line is, why trade? Doesn’t this apply to any policy, not simply trade? Or, we already know that people are afraid of trade?

I am sensitive to this but I think the trade argument is important because of the special status free trade has within economics.

Perhaps, my perception is way off but I think that most economists feel comfortable asserting that the gains to the winners from trade liberalization will outweigh the losses to the losers except in the following cases:

1) There are externalities.

2) There are unexhausted returns to scale.

I am offering a third and I believe more general critique. The very fact that there are winners and losers is inherently costly. Unless you know for certain exactly who those winners and losers are, you are imposing uncertainty on the world.

It is possible that the cost from this uncertainty outweighs the gains from trade liberalization.

In fact, it is possible that freer trade is unambiguously a social ill. That is, the increase in uncertainty could make every single person in the world worse off because of freer trade. In this case there is no social welfare function that would rate this as a good idea.

Since this is a theoretical possibility, the notion that the gains to the winners outweigh the losses to the losers becomes an empirical question that is almost impossible to rule out a priori.

Now, I think that distributional uncertainty is an issue that goes beyond trade. Indeed, I think it affects any policy we might consider. However, I do think that trade is unique in the level of confidence economists display about policy prescriptions.

In a survey reported by Robert Whaples 90.1% of economists disagreed with the suggestion that US should restrict outsourcing.My guess is that the 10% who agreed did so primarily on the grounds of equity and that most of those who disagreed felt that in the absence of externalities or a returns to scale argument trade unambiguously promoted the general welfare.

I am challenging that assumption.

Oldies but Goodies

2007-07-25T14:47:00.000-05:00

So to finish working on Losses from Trade I am reading

The Foundations of Welfare Economics

and

Welfare Propositions of Economics

They are both fun reads, especially the first. It is wonderful just how careful these guys were.

Losses From Trade

2007-07-13T13:48:00.000-05:00

A draft of the idea in the last post.

Tear it apart :)

Kaldor Hicks Preview

2007-07-12T10:25:00.000-05:00

Gabriel says that I should post my ideas no matter how nascent because lets get real, whose gonna want my ideas.

So here is one that I have been kicking around promising myself that I would finish the write up on but haven’t gotten around to it.

Kaldor-Hicks tends to overestimate the net benefits of a policy whose distribution is uncertain.

That is, when we think about whether a policy is a good idea we do a cost-benefit analysis. We add up all the costs to whomever they occur and all of the benefits to whomever they accrue. If the benefits are greater than the costs we declare the policy to be efficient.

Perhaps, the policy is not equitable but it is efficient. The winners could compensate the losers and be better off.

Now the problem is that the winners don’t compensate the losers. And, that’s not just a problem for the reason you think it is. We all admit that the distribution of the gains may be such that the winners don’t personally value their gains as much as the losers personally value their losses. However, without the ability to do interpersonal comparisons we are stuck.

Yet, there is another problem. If the distribution of the gains is not certain then the individual agents will value them at less than their face value. Likewise if the distribution of the losses is not certain than the individual agents will value them at more than there face value.

This means that even if the total benefits outweigh the total losses with certainty, uncertain distribution can lead to individual agents perfering not to make the trade.

To drive the point home I create the following example:

There is a policy were the gains to the winners outweigh the losses to the losers with certainty but NO AGENT wants to see the policy enacted. That is, there is a policy which passes cost-benefit analysis but is uniformly rejected by each person affected by it.

The simplest example is easy. Suppose that the benevolent government is offered the following deal. One million of your residents will be selected and given $100,000. Another one million of your residents will be selected and charged $99,999.

To make matters simple only residents who have at least $99,999 will participate in this program. However, whether the resident is a winner or loser is chosen at random.

This program seems like an economic free lunch. The gains are guaranteed to outweigh the losses by $1 million. The selection process is completely random, so there are no economic distortions. In fact, there is no a priori reason to expect that the winners will have lower marginal utilities of income than the losers.

Yet, we could expect that every single agent will reject this program. Why? They reject it because the program exposes them to risk. The cost of that risk outweighs the expected benefit of program.

Perhaps, the agents could insure against the risk. Since the expected gains are positive they should be able to write a contract that splits the expected gains with an insurer so that everyone winds with more than what they started with.

However, what if I said that I am not going to announce the winners and the losers? I am simply going to subtract the losses from the losers net worth and add the gains to the winners net worth with no record of the transaction. How could one insure that?

If this seems a little far fetched and unrelated to real world issues, allow me to change the offer again. Rather than simply adding $100,000 or subtracting $99,999 I am going to do this.

The winners will receive an increase in the demand for their services and a pay raise. The losers will see their jobs outsourced to Asia. The winners won’t know for sure why they lost they received a raise. The losers won’t know for sure why they lost their job.

To add another layer of realism lets change the terms a little. I won’t change any of the expected values but this time instead of selecting 1 million winners and giving them each raises worth $100,000, I will select 100 million winners and give them each raises worth $1000.

The expected gains from this deal are still $1 million. Does anyone want to go for it?

There are two insights that I draw from this thought experiment.

1) That distributional risk is a real concern in policy. If the winners don’t know they will be winners and the losers don’t know if they will be losers the policy will seem better than it really is.

This was the idea that I started with. Workers I talked to disliked outsourcing not just because some people did loose there jobs but because they felt like any of them could loose their jobs. The difference is subtle but important. The first is just about direct costs; the second includes a notion of risk.

2) The second insight I take away is that just as Von Neumann / Morgenstern risk comparisons allow us to define cardinal rather than simply ordinal utility. Who-will-gain risk comparisons allow us to define a sort of interpersonal utility comparison. If you had an equal shot of being on any end of this policy would you still support it? Its not exactly interpersonal comparisons but it carries much of the intuition we want to gain from it.

Comments? Suggestions?

Prior Trap Preview

2007-07-10T09:38:00.001-05:00

Arnold Kling has an interesting post on Inequality, that references Brink Lindsey's piece in the Wall Street Journal.

My October talk at GMU is going to be on the same issue that Lindsey refers to as the Culture Gap.

The type of facts that go to the heart of my concern and apperantly his is this:

Among students who received high scores in eighth grade mathematics (and thus showed academic promise), 74% of kids from the highest quartile of socioeconomic status . . . earned a college . . . 29% for those in the bottom quartile [did as well].

That is socio-economic status seems to have an effect independent of ability.

Lindsey argues that it is a cultural phenomenon. On one level I do not disagree.

However, I believe that "culture" is the rational extrapolation of unknown parameters from the behavior of people in your reference group.

Whew! In other words:

Look life is full of choices. The consequences of those choices depend upon the complex interaction of factors that you don't have the time or in many cases even the resources to understand. So what do you do? You copy the behavior people who seem to be doing well given similar circumstances. If you think Joe is doing good for himself and Joe has constraints similar to your own then you copy Joe. If Fred is screwing up royally and Fred was faced with the same choices that you had, you avoid Fred's behavior.

This is in part why people feel moved by an example "they can relate to." This is simply a way of saying the constraints in this problem as sufficiently similar to my own that I can use it as a data point.

When your circle is an unbiased sample of population consequences this works remarkably well. It is possible for people to make fully optimal choices in the face of no data, apart the actions and consequences of those around them.

In other words, to be successful you don't have any clue about how the world actually works, you only have to learn from the experience of the people around. This is nice because in academia some of the smartest people, with the most powerful computers and the largest data sets spend all day trying to understand how the world actually works and they still have no clue.

When your sample is biased, however, you can be steered off track. If everyone you see is a high school drop out and most of them are just as smart as you, then what makes you think that you can or should finish high school, let along go to college.

Remember that investing in education requires giving up work and leisure today for the possibility of gains tomorrow. Working at McDonald's or spending time with you friends pays off with probability one. College? Well in a world where the only person you know that has graduated from college is your teacher, what are likely to conclude about the expected return from that investment.

The corollary to my theory is that good teachers are not ones who have high instructional ability but high motivational ability. Good teachers encourage already successful students to push themselves even harder. Good teachers can relate to at risk students and convince them that the pay off from education is indeed positive.

Rick Hanushek shows that working with great teachers four years in a row can eliminate the performance gap between low income and high income students However, what makes a great teacher has little to do with education or experience. He says that the missing factor is unknown but probably innate.

I suggest that the missing factor is the ability to gain a student's trust. The ability of a teacher to convince a student to disregard that giant data set called her community and instead believe the message the teacher is painting. This often requires disregarding parents as well. After all, poor parents are disproportionately likely to be people who estimated a low expected return to education themselves.

Whats Going On

2007-07-03T08:47:00.000-05:00

A commenter asks just how slow this summer is going to be.

Pretty slow I am afraid. In fact, I think I am quasi-retired for the time being.

The incentives in Academia being what they are I have to concentrate on writing for other economists before I can get back to writing for the blog.

My feeling is that it is better to wait and come back full-time rather than popping the occasional post every week or so.

If people feel differently then I can start posting on a when-I-have-a-moment basis.

The Argument against Gouging

2007-05-16T10:42:00.000-05:00

In the wake of concerns about rapidly increasing gas prices and the resurgence of anti-gouging laws, I wanted to take a moment and think about whether there could be any economic justification for preventing price gouging. That is, is there any way of framing the problem so that economists would agree that anti-gouging laws are good for society as a whole.

To be clear, anti-gouging laws will help some people. Most economists, however, believe that when all is said and done such laws hurt more people than they help. I am skeptical. I am skeptical because I am always skeptical. I am particularly skeptical because the public reaction is so hardily in favor of such laws.

Collective ignorance is hard bullet for me to bite. That’s not to say that it doesn’t happen, just that it takes heavy doses of evidence to convince me that it’s true. I should say also that collective ignorance and mass ignorance are two different beasts. It is entirely possible for people acting in a society to arrive at the right conclusion even if each individual has no idea what’s going on. Call it social emergent intelligence.

The first culprit when trying to reconcile a difference in opinion between economists and the public is on distribution. Economics proper is largely silent on how wealth is distributed; the public cares a great deal.

So, what does price gouging do to the distribution of wealth. The most obvious answer is that it transfers it from costumers to sellers. This is true but for various reasons I find it unsatisfying. What interests me more is the transfer between customers.

When the price of something goes up people buy less of it. True enough. But, who are those people? Does everyone buy less of it? In particular, do the poor reduce their consumption more than the rich?

That depends in part on whether the good is a luxury or a necessity. When the price of luxuries go up, poor people stop buying them in droves but the rich only cut back a little. On the other hand, both the poor and the rich try to hold on to their necessities as long as the can.

Now let’s just say for the sake of pure argument that a person must have a few basics to survive including gasoline or some much more expensive alternative. The cost of the basic level is almost the entire budget of the poor but a small fraction of the budget of the rich.

Enter price gouging. The back drop is this: War destroys the US oil supply. There is a shortage of gasoline. Oil companies can respond one of two ways. The first is that they turn to the price system and keep increasing the price until demand falls. The second is some sort of non-price rationing like waiting in really long lines.

What happens if the oil companies choose the price system or gouging as the politicians call it. The price of gasoline keeps rising and rising and rising and doesn’t stop until demand falls to match supply. If the price rises to the point where the more expensive alternative is available then the wealthy will switch to it and all will be well.

However, what happens to the poor who could not afford that alternative to begin with? In this example they all die. They needed gasoline or the alternative to survive. They could only afford gasoline. Since the price of gasoline rises to the price of the new alternative they don’t survive.

What would happen if we used non-price rationing? In this example, the worst that could happen, even if you picked a rationing system at random, is that the poor still die. If the lives of any of the wealthy are threatened by the rationing system they will just turn to the more expensive alternative.

However, the lives of some of the poor could be saved. If the rationing system differs in anyway from the price system then more people will live. Said another way, price gouging is the worst possible thing that could happen.

For the nerds out there what is going on is that willingness-to-pay is not accurately measuring the utility gain because of budget constraints. The poor are forced into a corner solution. The poor would really like to trade consumption from states of nature without gouging to states of nature with gouging but cannot because of incomplete insurance markets. As a result relatively small utility gains for the rich are paid for with huge utility losses to the poor.

The death example is extreme but it is only for the purpose of clear illustration. No one disputes that death involves a large loss of utility. However, the poor could simply lose their jobs, not be able to take their kids to day care, or not be able to visit a dying relative. In any of these cases gouging could be worse than the alternative.

hat tip to mankiw

Summer Lull

2007-05-15T09:29:00.000-05:00

Posting will be light for much of the academic summer. Thanks to all the regular visitors.

The Evolution of Economic Psychology

2007-05-10T10:59:00.001-05:00

Paul Rubin echoes an argument popular in economics and business circles these days. Most people fail to appreciate the gains from trade and immigration because they are trapped by Neolithic analysis. They see outsiders as threats to the tribe. They view competition as a zero sum game and they over-estimate the importance of anecdotes. What they really need is a good dose of economics education.

There is a part of me which is inclined to agree. Certainly impetuous young freshman, eager to change the world, often transfer models of small group interaction to the national stage. They forget the costs of information. They are unaware of the wide dispersion in preferences. They consistently overestimate the effectiveness of deliberate social pressure. They are also vulnerable to the Neolithic traps Rubin describes.

In my experience, however, the average person is more immune to those types of errors. Such analytical errors are most prevalent in white space thinking; the kind that passionate intelligent college students revel in.

Most people, however, rely on experience. Indeed, experience is so important in the modern world precisely because instinct is so ill suited to it. But that is another post. Trade and illegal immigration are so hated in the decaying cities of the Rustbelt, in the ghost like mill towns of Carolina, and in the crammed exurbs of Southern California because their experience with it is so horrific.

Some Americans see that and think, “That could be me” but more see and think “but for the Grace of God that would be.” The difference is subtle but important. The first involves a mistaken estimation of probability, the second a sympathetic heart. Both might be born out our evolutionary past, but the later is no less relevant today.

The real question is why so many economists are so quick to dismiss such objections as ill formed. The first question shouldn’t be why is this person wrong, but how can I understand what they are really complaining about. Is it truly a misestimation of the dangers of trade, or is it a cost that we have failed to pick up? Is sympathy an important externality? Is fear of change a real largely uninsurable cost? Do social spillovers induce a particular and non-linear pain when children have to leave home to find a job elsewhere?

These are the questions we should be asking, but perhaps the psychology of economics isn’t as evolved as we like to think.

Hat tips: Mankiw and Caplan

Signal to Noise Ratio

2007-05-08T11:14:00.000-05:00

Will Wilkinson takes a walk on the dark side. He agrees with Bryan Caplan that education is mostly just a signal that you are already talented and suggests that there is “a huge entrepreneurial opportunity for whomever can come up with an alternative scheme of credible human capital certification”

My longstanding objection to the signaling hypothesis is two fold

1) The market abhors unclaimed profits. That is, it is hard to imagine that individuals in the economy are spending vast resources on something which is largely useless and that profit maximizing firms are rewarding them for doing so!

2) There is little to no evidence for the signaling hypothesis. The evidence shows that when we control for ability the return to college goes up, not down. For me this explains why nerds tend to find school useless. It was useless for them. That doesn’t mean that it’s useless for everyone.

My own theory is that the human capital formed in higher education is the ability to solve problems, manage time, work independently, seek out assistance, communicate your ideas, form and in some cases direct teams. These skills, not knowledge are what employers want.

Traditionally education focused on the classics for the same reason that athletes run hills. They’re hard. It’s not that your ability to run hills signals your ability as a football player or wrestler. It makes you a better football player or wrestler.

Now in athletics there was a revolution in “sport specific training.” That is, some people said “hey why don’t we have these kids train in ways that are actually related to the sport they are playing.”

It made a difference but not a huge one. The key factors of strength, speed, motivation, endurance, emotional self-discipline and tolerance for pain where sometimes better honed under conditions that had nothing to do with the actual sport.

Education, I believe, operates mostly the same way. The skills needed to direct an engineering project are sometimes best honed by slogging your way through purposefully near impossible homework assignments. The understanding of unintended consequences needed for white space thinking in big business may come best from analyzing why it is that none of your favorite economic policy proposals work out the way you thought. The communication skills needed to lead a company through restructuring my first come from writing and rewriting an essay that can persuade a stern professor that Hume is properly considered an atheist, not a deist.

In each case it is the skill set that is important. The knowledge is relatively unimportant.

hat tip to Kling

Technology and Trade

2007-05-08T09:49:00.001-05:00

A reader asks where technological change fits into the analysis below. This question goes right to the heart of the matter. For trade to increase GDP without increasing factors trade must induce some type of technological change.

It seems pretty straight forward how this might happen with less developed countries. Technology transfer from the West pushes them closer to the frontier.

The argument gets a little more complex when you start thinking about developed countries. Anyway you slice it you are going to have to give up constant returns to scale to get technological growth from trade.

The options I see are:

1) The market for advanced technology grows which increases investments in R&D.

2) There are spillovers at the international level. That is, American firms learn techniques from foreign firms and vice versa. This is a little bit different than the first because a technique might be something like Total Quality Management which isn't quite the same as a new technological device.

3) Efficiency through dynamicism. I haven't seen this as a model but I think many economists believe that robust competition in and of itself can push the technological frontier. I think many observers would agree that AMD's competition with Intel was key in speeding up the development time in semi-conductors.

However, as I have said before once you open the door to these type of non-linear effects then the trade argument becomes much much more complex. For Example, it could be the case that increased trade gives the wealthier countries the opportunity to crush foreign competition early on. If you believe the dynamicism argument this might be bad in the long run.

What Happens to A Market Disturbed

2007-05-07T17:20:00.000-05:00

There seems to be some confusion about the difference between welfare loss and GDP loss. Welfare loss (in partial equilibrium) is approximated by the Harberger Triangle. In the graph above C.

Partial equilibrium GDP loss is how much smaller the market is. In the graph above that is A - B. We measure the size of the market as quantity X price.¹

It is entirely possible for the Harberger Triangle to be large and the GDP loss to be negative. That is, a tax could decrease welfare but increase GDP.

Moreover, in general equilibrium GDP loss can only come from decreased production. For most of our models that means that either there has to be less labor supply or less capital. Same labor, same capital implies same GDP.

Why is this important.

First, in most cases I believe GDP losses are significantly smaller than welfare losses. I may be able to prove this always true but I have to think about it.

Second, the standard answer that economists give when talking about the losses from taxation, tariffs, regulation, etc is a welfare measure. Yet, policy makers hear a GDP measure. In the back of policy makers minds they are already converting GDP to welfare. If you give them the wrong number they will convert twice and really overestimate the loss.

(1) Just as in Harberger case we assume that taxes are lumped summed back and spent on something else.

What's New About the New Offshoring

2007-05-07T07:41:00.000-05:00

I am happy that economists like Alan Blinder are rethinking the consquences of free trade. It is too easy for most economists to conflate flawed reasoning with a flawed position. Even fools are right sometimes.

This, I believe is the case with free trade. The fact the anti-free trade crowd espouses a reasoning that does not hold up to scurnity does not imply that they are necessarily wrong.

Blinder's critque brings up the heart of the issue. There will be a transition process. That process will be difficult for some people. To the extent that we care about those people, we must be aware the consquences of globalization and be prepared to address them.

Moreover, it is in our naked self-interest to do so. A favorite quote of mine:

Why do we care about the poor? Because when they revolt, they always hang the elite.

Perhaps the new message should read:

Why do we care about the upper middle class? Because when their jobs are threatened they always vote out the current administration.

If there is anything new about the new offshoring then that's it. Its not how I would have prefered to gain allies, but I'll take it.

Nothing New Under the Sun?

2007-05-05T11:18:00.000-05:00

Interestingly, my background research on "cognitive capital" turns up some work by McFadden and others around 2000. The really cute thing is that they actually use the term "cognitive capital" and in roughly the same way I use it.

As far as I can tell the work seems to be mainly empirical in nature, primarily focusing on experiments. I have not yet seen a formal theory. If anyone has seen one let me know. I think there is some really cool work to be done here.

If you can model comprehesion as a produciton function of cognitive labor and cognitive capital then the Inada conditions should hold. If you combine that with non-linear depreciation my guess is that the importance of early childhood eduction/mental stimulation will fall right out.

Varian's Point Still Stands

2007-05-05T08:59:00.000-05:00

So there has been a bit of a scuffle about what Ilia Dichev's paper really meant. Turns out I was wrong. The sole point is that the supply of stocks on the market changes as the market goes up and down.

Companies issue more stocks when the market is high, and they buyback more stock when the market is low.

So if you are buying into a rising market then you are buying into increasing supply. If you are selling in a falling market you are selling out of decreasing supply. That is, if you time the maket the way most people would try to then the basic forces of supply and demand are working against you.

Thus, you are better off buying and holding. Now that might also suggest that its better to take the Buffet strategy of buying against the market and then holding. But of course we know that seems to work. Its just that the opportunity cost is paid in stress.

A Theory of Cognitive Economics

2007-05-04T10:57:00.000-05:00

One of the ideas that I have been kicking around is integrating some behavioral observations into a theory of cognitive economics.

It seems to me that many of the observations that come out of behavioral economics could be explained by two facts:

1) Thinking is hard.

2) People gain utility from imagining things that will never happen.

Both of these facts seem to be born out in everyday experience. Any professor knows that the first is true. Thinking must be hard. If it wasn’t then we wouldn’t have to offer students incentives to do it.

This fact can explain a lot of why people use rules of thumb and other short cuts when making choices. The cost of thinking simply outweighs the benefits. To explain why people who engage in relatively sophisticated thinking on a regular basis still use short cuts we simply need cognitive capital.

There are tools that we gain for thinking about certain types of issues that are not easily transferable to some others. Perhaps, mathematics can be seen as a particularly high return form of cognitive capital.

The second fact is perhaps less obvious but I think can explain a lot. Sometimes people purchase products which they do not use. Outside observers could easily predict that the person will not use them, so then why do they buy them?

Well, one reason might be simply cognitive consumption. The thought of myself going to the ballet all season long might be enough to get me to spring for season tickets, even if in reality chances are that I will miss most of the shows.

I am faced with two options. Option one, I buy season tickets and consume both the shows that I see and the thought of the seeing all of the shows. Option two, I buy the tickets individually and consume the shows I see and the thought only of the shows I see.

If the benefit of thinking about seeing the shows I actually missed is worth more than the additional cost of the season tickets I will buy the tickets. I will also be better off from having done so.

In a sense the tickets are a compliment to my imagining myself going to the show. The imagination is richer and fuller if I actually have the tickets.

I believe that an increasingly important part of our economy consists of cognitive capital and items which are complements to cognitive consumption. Understanding what these are and establishing the associated elasticities could enrich economists' ability to predict how individuals will actually behave. I hope this is true, but its hard to figure out. For all I know this could all be one exercise in my own cognitive consumption.

Paper Inspired By This Blog

2007-05-04T07:41:00.000-05:00

A reader asks about the paper I promised a while back. I don't want to let the cat to far out of the bag until I have a working paper developed a little further. It will take a bit more work before I have clearly establish the concept as my own.

Here is the idea though. It is possible to constuct a policy that passes benefit-cost analysis but no single person in the economy wants the government to adopt.

This is a real problem for economists. When lean on benefit-cost analysis by saying "look we can't compare happiness between people. Thats a moral judgement. All we can do is maximize the material wealth of society"

But what if maximizing the material wealth lead to a policy that no one wanted. Surely that can't be right. The way I say it is that there is no social welfare function that would choose this policy.

It doesn't matter whose values you use because no one wants the policy.

The conditions that make this true are stringent. Most policies can probably find at least one person who is in favor of them. However, it does mean that benefit-cost analysis could loose it's intellectual safe haven. That would mean that we would have to engage in the messy business of figuring out who benefits and who looses.