Category Archives: links to my essays

Russ Roberts Asks an Easy Question

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He writes,

There are lots of claims about inequality and what is really going on. But this chart makes whatever explanation you believe in harder to explain. Chew on it.

Nick Schulz and I wrote about what we called the Sergey Brin Effect. We pointed out that the “game” of income distribution has been re-shaped by immigration, assortative mating, and technology.

The chart the Roberts refers to shows major differences in trends by education category. It also shows that, controlling for level of education, women have done better than men. My guess is that this is due to technology. We have seen an increase in the comparative advantage of people who can get into well-protected credentials cartels or who can help companies formulate and execute complex business strategies. I think that explains the education-income trend. We have seen a decline in the comparative advantage of workers who are good at lifting, shaping, and applying finishing to metal but who are not so good at interacting with customers and co-workers. That also explains the education-income trend, but I think it also helps explain the male-female trend.

The chart also shows more earnings growth at the top of the education ladder. That, along with assortative mating by education, should really drive household inequality.

What is Financial Repression?

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Ken Rogoff and Carmen Reinhart are still paying attention to sovereign debt. In fact, there are so many links in this paper to recent work of theirs that surely another book is in the offing. Here, they write,

the current stage often ends with some combination of capital controls, financial repression, inflation, and default. This turn of the pendulum from liberalization back to more heavy-handed regulation stems from both the greater aversion to risk that usually accompanies severe financial crises, including the desire to prevent new ones from emerging, as well as from the desire to maintain interest rates as low as possible to facilitate debt financing. Reinhart and Sbrancia (2011) document how, following World War II (when explicit defaults were limited to the losing side), financial repression via negative real interest rates reduced debt to the tune of 2 to 4 percent a year for the United States, and for the United Kingdom for the years with negative real interest rates. For Italy and Australia, with their higher inflation rates, debt reduction from the financial repression “tax” was on a larger scale and closer to 5 percent per year. As documented in Reinhart (2012), financial repression is well under way in the current post-crisis experience.

(Can anyone find the 2012 paper? It’s not listed in the references.)

Reinhart’s story is that once upon a time, countries emerged from WWII with a lot of sovereign debt. They used financial repression to keep interest rates low, and they got out from under that debt. Then they liberalized, and the financial sectors went crazy, growing rapidly and fueling bubbles. Then the crash came, governments took on a lot of debt again, and now we are back in the cycle of financial repression.

As a story, this is cute. But I cannot buy into it, at least for the United States. Re-read my history of U.S. government debt. Most of the reduction in the ratio of debt to GDP from 1946-1979 was due to the government running primary surpluses in the 40’s, 50’s, and 60’s. That is, if you took out interest payments, outlays were below revenues. The negative real interest rates were during the Great Stagflation, and they only reduced the debt/GDP ratio by a small amount.

Also, I am not sure where the financial repression is coming from today. Reinhart cites risk-based capital requirements that favor sovereign debt, but we have had those since before the financial crisis.

I think my larger issue is that I am unclear about the concept of financial repression. Some possibilities.

1. Financial repression consists of regulations that subsidize purchases of government debt and/or penalize risky private investment. In this case, the interest-rate differential between private securities and government securities is wider than normal. How does one distinguish this from a shift in the risk premium due to market psychology?

2. Financial repression reduces the amount of financial intermediation. But what does that mean?

To me, financial intermediation consists of the financial sector holding long-term, risky assets and issuing short-term, risk-free liabilities. The nonfinancial corporate sector and the household sector get to issue long-term, risky liabilities and to hold short-term, risk-free assets. The household sector ultimately owns the equity in the nonfinancial corporate sector and in the financial sector. The government, through deposits insurance and ad hoc bailouts, has in some sense written put options on firms in the financial sector, and as taxpayers we are on the hook for those put options.

If the government comes up with regulations that make it more difficult for the financial sector to expand and exploit its put options, then you might call that financial repression. But in that case, it is not clear that financial repression is a bad thing.

Romneycare Update

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Philip Klein writes,

As Modern Healthcare reports:

Massachusetts, whose health care reform program was used as a template for the Patient Protection and Affordable Care Act, had the highest per capita health spending in the U.S. in 2009. According to the commission’s report, the state spent $9,278 per person on health care in 2009, which was 36 percent higher than the national average of $6,815, and 11.2 percent more than the next-highest state, New York, which spent $8,341.

When Romneycare was enacted, I wrote,

If more Massachusetts consumers enjoy coverage without any deductible, then the average per-person expenditure on health care of $6,000 seems likely to go up.

Indeed, it seems that per capita health spending went up over 50 percent in just the first three years under Romneycare. At the time, many of its proponents were saying that Romneycare would hold down health care spending.

When people are insulated from having to pay for health care, health care spending goes up. You might want to insulate them, anyway. But the theoretical ways that you reduce spending–by cutting down on emergency room visits, or through better prevention–do not pan out in practice.

Fun Re-reading

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For the macro book that I am working on, I wanted to refresh my memory for how the financial crisis played out. I went back to blog posts that I wrote in 2007. You can find them here. Scroll down to December, and look for posts “subprime daily briefing” (sometimes named slightly differently).

I staked out an early position against bailing our borrowers. I have no regrets there. At one point I said that the total wealth loss from the crisis would not be as large as the loss from popping the dotcom bubble–I think I was wrong about that.

I also staked out an early position in favor of capital forbearance by bank regulators, meaning that they would not force banks to sell assets at distressed prices to meet capital requirements. I still think that compared with what regulators actually did, this was a better approach.

Also interesting are the various links from the posts. For example, I found a paper by Michael Bordo, dated September 28, 2007.

Many of the financial crises of the past involved financial innovation which increased leverage. The 1763 crisis was centered on the market for bills of exchange, Penn Central on the newly revived (in the 1960s) commercial paper market, the savings and loan crisis of the early 1980s on the junk bond market, LTCM on derivatives and hedge funds.

In the most recent episode, the financial innovation derived from the securitization of subprime mortgages and other loans has shifted risk away from the originating bank into mortgage and other asset backed securities which bundle the risk of less stellar borrowers with more creditworthy ones and which were certified by the credit rating agencies as prime . These have been absorbed by hedge funds in the US and abroad, by offshore banks and in the asset backed commercial paper of the commercial and investment banks. As Rajan ( 2005) argued, shifting the risk away from banks who used to have the incentives to monitor their borrowers to hedge funds and other institutions which do not, rather than reducing overall systemic risk increased it by raising the risk of a much more widespread meltdown in theevent of a tail event as we are currently witnessing.

Larry Summers on the Great Factor Substitution

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He said,

If there are only two factors, they have to be complements. If there’s more capital, the wage has to rise. Now imagine that…you can take some of the stock of machines and, by designing them appropriately, you can have them do exactly what labor did before…When capital is reallocated to substituting for [replacing] labor, the stock of effective labor rises and the stock of conventional capital falls, and so wage rates fall. Third, the capital share, understood to include the total return to capital of both varieties, rises. That’s just a corollary of output rising and wages falling. This pattern is similar to what we have seen take place. I suspect that this reflects the nature of the technical changes that we have seen: increasingly they take the form of capital that effectively substitutes for [replaces] labor.

Pointer from Tyler Cowen, who I’m surprised did not make a bigger deal about it.

My one quibble/criticism is that this describes a closed economy. In the real world, with China and India developing, factor-price equalization is at least as important as factor substitution. To put this another way, include those countries when you calculate trends in labor’s share of income.

Also, Summers writes,

Where production has taken place in the classic way we teach, productivity growth has continued. There has been progress. Real wages measured in those terms have increased substantially. It’s just that a larger and larger share of our economy is in sectors that are not well thought of as widgets produced by competitive firms. They are sectors where property rights, scarcities, intellectual property, and the like are of fundamental importance.

My take on this is to be wary of talking about “the” real wage. Your real wage is much higher if you abstain from making extravagant use of modern medicine and private colleges. See The Reality of the ‘real wage’.

He concludes by raising the issue that Nick Schulz and I called the New Commanding Heights. Summers writes,

Whether the expansion of those sectors as a share of the economy necessitates a growing share of the public sector in the economy, or whether the share of healthcare and education that takes place in the public sector should decline will be a matter of great public debate. As a country, and not without controversy, we do not seem to be moving toward a smaller public role in healthcare. Nor do other countries in the world. But that will, perhaps, change over time.

Antonio Fatas Starts a Discussion

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He wrote about what he sees as four missing ingredients in mainstream macroeconomics. Let me focus on his last two:

There is plenty of evidence that price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions in the real economy that produce a slow adjustment and are responsible for the persistence of business cycles.

… The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research.

Robert Waldmann adds,

I think the problem is that with coordination failures, multiple equilibria are possible. Not just two or two hundred either, but a large infinite number. There is no theory which tells us how likely different equilibria are. Worse, policy shifts can cause the economy to jump from one equilibrium to another in unpredictable ways.

This does not strike me as an argument against the validity of models of coordination failure. In fact recessions are hard to predict and, well, look like panics. The problem is that models which say that macroeconomists will not be able to predict well are not popular.

Pointer from Mark Thoma.

When I wrote one of my PSST papers, Peter Howitt’s response put it in the coordination failure literature. In fact, I think there is a (possibly slight) difference. “Coordination failure” sounds to me as if there is a great equilibrium sitting there, and people just cannot find it. I think that the patterns of sustainable specialization and trade need to be discovered, through trial and error.

I believe that even if there were no frictions impeding coordination, as long as entrepreneurs have to test business models without knowing whether they will work, there will be business models that fail and unemployment can result. However, this is a weird hypothetical, since there is obviously no such thing as an economy with frictionless coordination.

So my view of what macro needs would include coordination failure of a variety of types, as well as trial-and-error learning. In my opinion, the resistance to this comes from various sources:

1. As Waldmann says, you have multiple equilibria. In fact, you never get to any one equilibrium, so that the very notion of equilibrium as a core modeling element loses salience. That creates a ton of discomfort.

2. The system is no longer hydraulic, in which more X (fiscal stimulus, monetary growth) leads to proportional increases in Y (GDP, inflation, employment). For many macroeconomists, the whole point of modeling is to come up with implications for fiscal and monetary policy. The idea that your model may not lead to a cure for business cycle makes the effort seem pointless, at least in compared with Keynesian can-do thinking.

3, It is inconsistent with popular modeling simplifications, such as the “representative agent.” For the purpose of publishing papers in journals, economists like to gravitate toward standard models. It is much easier to get published if you do a variation on a standard model than if all the people working on an idea are just groping around in different ways. I think that the coordination-failure approach to macro involves this disparate groping, and thus it suffers from….a co-ordination failure, if you will. The DSGE folks can co-ordinate. The rest of us can’t. So even though the DSGE stuff is a blind alley we have better ideas, when it comes to the journal process, we lose.

Medicaid = Nursing Homes

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Harold Pollack writes,

If we want to provide more cost-effective care to poor people, we should proceed in the same way that we should proceed in other parts of the medical economy. We must do the hard work of improving the quality and economy of care provided to the concentrated group of extremely costly patients. There is no short cut. Under any financing system, this requires the hard work of clinical-care coordination, quality improvement and social services to address life circumstances that undermine health.

Pointer from Tyler Cowen. His main statistical argument is that a small percentage of Medicaid patients account for much of the spending. It is likely that these are patients in nursing homes.

However, this does not answer the question of where there are opportunities to save money in medical care. Some possibilities.

1. Death panels. To the extent that late-stage treatments are wasteful, you have to change the decision-making process. Families and would-be heroic doctors need to have less influence.

2. Reducing procedures, such as back surgery, with high costs and low benefits. In Crisis of Abundance, I argued that there is in fact a large “gray area” of medicine, in which procedures are neither absolutely necessary nor absolutely unnecessary. This is counterintuitive, and if you do not believe it, then you end up siding with Pollack. If you do believe it, then having patients pay more of the cost of treatment could be a big deal.

3. Improving management in health care, particularly of patients with complex illnesses. My guess is that if there are big savings to be had here, they come from reducing the status of doctors relative to managers, social workers, and care-givers with lesser credentials. See Does the Doctor Need a Boss? I would not bet that government will be successful at re-engineering the system, and in fact regulation of medical practice is probably a major inhibitor.

4. Innovation in treatment. My concern would be with the Food and Drug Administration. They want to err on the side of keeping treatments off the market. We might be better off if their task was shifted to funding and publicizing research, not actually regulating.

Occupations of the Future

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David Brooks writes,

Millions of people begin online courses, but very few actually finish them. I suspect that’s because most students are not motivated to impress a computer the way they may be motivated to impress a human professor. Managers who can motivate supreme effort in a machine-dominated environment are going to be valuable.

Actually, I think that a big reason that people drop online courses is that those courses are a misfit for them. An advantage of a typical live course is that most of the students have been selected to have similar abilities and experiences. A lot of people sign up for online courses who otherwise would be discouraged from doing so. That is not necessarily a problem with online learning.

However, that is why MOOCs are not the answer, in my view. My line is that we need instruction that is many-to-one, not one-to-many. Indeed, Jonathan Haber suggests that MOOCs might be a step backward, and he links to something I wrote in 2002.

suppose that we had all of the highly-touted electronic technologies for distance learning, and then someone came along and invented the book. My guess is that the book would be greeted as a technological marvel–easy to hold, convenient to carry, outstanding resolution, and so forth. This thought experiment leads me to suspect that electronic distance learning is a fad.

On the subject of the future, my joke is that the ideal occupation will be a yoga instructor working in an old-age home. That lines up with the trends toward more spending on health care, education, and leisure, along with an older demographic.

Will They FUBAR Mortgage Finance, Too?

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James Stock said,

It is hard to see how a private guarantor could credibly provide full insurance because of its inability to diversify against severe common, or macro, risk. The presence of a government guarantee, as opposed to a private guarantee, resolves the credit risk asymmetric information problem associated with MBSs that do not yet have their constituent mortgages fully specified. With this asymmetric information problem resolved, the TBA market provides liquidity, hedging, and price discovery to the mortgage market.

Thanks to Nick Timiraos for the pointer.

What Stock is advocating, and what seems to have the support of the Obama Administration and many in Congress, is a completely new business process in the mortgage industry, with a government guarantee of mortgage securities as the critical element. As you read this, I am appearing on a panel of experts who take a different point of view.

In my contribution two years ago to a Mercatus center collection of alternative proposals, I stressed the danger of trying to stand up a completely new set of institutional arrangements in the mortgage industry. I was worried that implementation could prove troublesome. That argument might not have seemed so powerful then, but maybe in light of healthcare.gov it might get more attention now.

In my presentation to the panel, I will say that a government mortgage guarantee is like the ethanol mandate. Whatever the alleged public policy justification, it is really a special-interest handout. See Your Mortgage, Their Rent. Of course, just as with the ethanol mandate, it will be very hard to stop and, once in place, impossible to kill.

I am so pessimistic about the politics of housing finance reform that I think that the best hope would be to try to create a restrictive charter for the new government guarantee agency. Make it illegal for the agency to guarantee cash-out refinances, second mortgages, investor loans, home-equity loans, negative-amortization loans, and ARMs. Limit the agency to owner-occupied mortgages, for purchase or rate-lowering refis, with fixed rates for 15 or 30 years. Getting that would be a huge victory, and it would not detract from any legitimate public policy goals, but I doubt that it is achievable. Wall Street and the housing lobby are going to have their way with the public, and we’re going to end up having to bend over and submit.

Wealth Illusions

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From Frederick Taylor’s The Downfall of Money:

In the end, no one really got their money, not even the Americans. Germany used the American loans it received under the 1924 Dawes plan to pay reparations to the French and the British, who in turn used the money to service their own debts to the USA. Then, during the Great Depression, all the major powers, including Germany, France and Britain, effectively defaulted on what they owed to America, and into the bargain the Germans defaulted on reparations.

This reminded me of one of Tyler Cowen’s mantras, that we are not as wealthy as we thought we were. His implied model of recent economic events is that we had illusory wealth during the housing bubble and then reality bites. Some random thoughts:

1. Taylor’s picture of the 1920s suggests a possible wealth-illusion story for the Great Depression. The Germans did not think that they were going to pay anywhere near the full amount of reparations, so they did not count that full amount in their liabilities. However, the Allies were counting on receiving the full amount of reparations (as my previous post on the book indicates, the citizens were led to expect even more than the political leaders were really going to try to collect). In effect, reparations were being double-counted as aggregate wealth, with consumers in the Allied countries counting them as assets but without offsetting liabilities in German households. Then, around 1930, Allied households finally marked down their wealth, and you had the Great Depression.

2. Macroeconomists know that Keynesian fiscal policy effectiveness depends on wealth illusion. The question “Are government bonds net wealth?” must be answered “yes” in order for deficit spending to raise aggregate demand. Otherwise, if Barro-Ricardian equivalence holds (so that the increased wealth of the holders of government bonds is offset by the decreased wealth of households who have marked up their future tax liabilities), then deficits are not clearly expansionary.

3. In theory, wealth illusions do not have to be destabilizing. Economic activity does not have to rise and fall just because people have higher or lower perceptions of wealth. Complete wage and price flexibility would be sufficient to maintain full employment. I am not sure that complete wage and price flexibility is even necessary. However, in practice it seems likely that wealth illusions would prove to be destabilizing.

4. From a PSST perspective, one can imagine all sorts of patterns of trade that depend on perceptions of wealth. When wealth illusions break down, it is not as if all households take an equally proportionate hit. Some households lose more than others. For example, when the housing bubble broke, people who had a lot of their (illusory) wealth in housing lost more than people who did not. So when (illusory) wealth is redistributed, old patterns of specialization and trade become unsustainable, and there will be unemployment until new patterns are established.

5. One could argue that the increase in government debt financed by quantitative easing is fostering a wealth illusion in countries where it is taking place. Indeed, that is in some sense the intent–see point (2). Perhaps we should be more worried than we are about how the process of unwinding this wealth illusion can be accomplished without pain. Actually, I am plenty worried about it.