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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

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

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

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

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

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

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

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

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

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

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

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

This is exactly what we wanted to prevent

T-Bill Rates Can Be Negative

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

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

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?

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

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

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

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.