Creating Inflation Consciousness

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Scott Sumner writes,

The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don’t need much QE, because the public and banks don’t want to hold much base money.

My reply:

1. Central banks have tried many times to commit to pegging exchange rates, which in principle seems easier to do than pegging an inflation rate. These attempts have often failed, as the central bank finds itself overwhelmed by private speculators. This suggests to me that one should be skeptical of the effectiveness of open-mouth operations.

2. Suppose that the Fed backed up its commitment to 4 percent inflation with a lot of action. My belief is that it would take a great deal of action–an order of magnitude more than what we have seen.

3. By the time inflation reached its 4 percent target, there would be a great deal of “inflation consciousness” among investors and in the general public. We would get into a regime of high and variable inflation. You do not know whether inflation would tend toward 4 percent, 8 percent, or 12 percent.

4. In this regime of high and variable inflation, prices would lose some of their informational value, as people find it harder to sort out relative price changes from general inflation. This would be detrimental to economic activity. Scott and I both remember the 1970s, and from a macroeconomic perspective, they were not pretty.

5. So fairly soon, you would see a reversal of policy, with Scott complaining about the stupidity of the Fed overshooting its inflation target. The Fed would take dramatic action to undo what it did before.

6. After several painful years, we would be back to the regime of low and stable inflation.

Bethany McLean responds

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In an email (which she gave me permission to post), she writes,

So first of all, thank you for your kind words about All the Devils. I’ve always been a fan of your work, and I wholeheartedly second the title of your blog! Secondly, I’m always fine with criticism of my work and disagreement with any interpretation I’ve made. In particular, the GSEs are a nuanced, difficult subject, and frankly, I learn new things all the time. I am always willing to change my mind if someone shows me that I’m wrong.

What I’m not ok with is mischaracterizations of my work, whether deliberate or because you didn’t actually read most of the book [her newest book, Shaky Ground]. My main reason for writing is that you say I dismiss Ed DeMarco as a free market ideologue. That is exactly the opposite of what I actually wrote, which is that you cannot dismiss him as just that! I think Ed is a good man who did the best job he could and held true to his beliefs – saving taxpayers money – under very difficult circumstances. I don’t want people reading your review to think I impugned someone’s character when in fact, I did the opposite. It’s really unfair of you.

You are intellectually dishonest about some other points as well, but frankly, everyone is intellectually dishonest about the GSEs, so I won’t bother with most of it. But since I’m writing, I’m going to point another one out.

You also say that the shareholders made a political bet, which they lost, fair and square. There are many different types of shareholders, but as I detail (gory detail – it’s hard to miss!) a number of them made a purely financial bet, and totally missed the poisonous politics. They did loan level analysis and saw that the GSEs were going to become profitable again. Their bet was not that they could buy special favors, but precisely the opposite: that the government would treat Fannie and Freddie as normal companies – ie, like AIG, like Chrysler, like the big banks. Which, not incidentally, is what Jim Lockhart said would happen at the time of conservatorship. And the government set up this situation by leaving the common and preferred shares outstanding. You can blame the investors for being politically naive, but I don’t see how you can fail to acknowledge that there’s a lot of blame to go around here. (It might be a fair point to say that the GSEs are only profitable again because of government support. But then, you’d have to say the same thing about the big banks. In fact, you’d have to say the same thing about our whole stock market, which is supported by the Fed! Etc, etc. )

I agree with your point about there being a powerful case to be made against the government caving into the housing lobby. Perhaps I do give in too easily to what I view as the political reality. That said, the history of the private market financing residential real estate is not a pretty one either! Look back to the booms and busts in the 1800s and the spectacular default rates in the Great Depression. I also would contest the idea that there is such a thing today as a private sector, as pertains to the mortgage market. If the big banks finance the mortgage market, they too will be GSEs, if they aren’t already. But on this, there is much grist for debate, and criticism is fair.

Anyway, the tag line on your blog, “taking the most charitable view of those who disagree,” is so important. Live up to it! Don’t set up straw men so that you can knock me down.

My remarks:

1. I am glad that she respects Ed DeMarco, and I am sorry that I interpreted her as siding with his opponents.

2. She and I will have to agree to disagree about the hedge fund investors in Freddie and Fannie stock. I see no role for financial calculation, or “loan-level analysis.” Instead, it would have been obvious that the GSEs could be restored to profitability if you kept them going long enough using Treasury funds to borrow while having the entire mortgage market to themselves. The wild, speculative bet was that in the meantime there would be no reform of the housing finance system and that politicians would then decide to return Freddie and Fannie to the status quo prior to 2008. However, neither the Bush Administration nor the Obama Administration indicated any intent to do that. If you bought GSE stock for pennies in 2009 or 2010, you were making a bet that could pay off spectacularly, but only if Congress and the Administration were to do something very different from what they were saying.

In dealing with the crisis, the only purist, follow-the-law approach would have been to put the firms (including big banks) through bankruptcy. I would have preferred that, although I understand the fears that policy makers had about such a process. In my view, the next best alternative would have been to nationalize the GSEs and the failed banks, on the grounds that taxpayers were on the hook for the losses of those firms. Then the government would gradually wind these firms down. Instead, the policy makers chose bailouts, which necessarily involved arbitrary treatment of stakeholders. I do not think that any of those stakeholders has a compelling legal complaint at this point, because the rule of law went out the window with TARP and the bailouts.

Just the other day, some bloggers at the New York Fed wrote,

our view is that an optimal intervention into Fannie Mae and Freddie Mac would have involved the following elements:

The firms would be able to continue their core securitization function as going concerns, supporting the supply of mortgage credit.

The firms would continue to honor their debt and mortgage-backed securities obligations.

The value of the common and preferred equity in the two firms would be extinguished, reflecting their insolvent financial position.

Note that last sentence.

3. For writing my earlier post, I have been subjected to vicious, ad hominem attacks from former members of the Fannie Mae lobbying arm. If nothing else were to convince me that restoring the status quo for the GSE’s is a bad idea, then these crude, juvenile social media posts would suffice. Perhaps government backing for housing finance is inevitable in America. But at least let us hope that the institutions that receive such support do not replicate Fannie Mae’s aggressive and unprincipled lobbying machine.

In an opinion piece in today’s WaPo, McLean dismisses this lobbying with an “everybody does it” line.

One legitimate complaint about the old Fannie and Freddie was the way they garnered political clout through their promotion of homeownership. In their heyday, it was immense and ugly. (“Fannie has this grandmotherly image, but they will castrate you, decapitate you, tie you up, and throw you in the Potomac,” a congressional source told the International Economy in the late 1990s. “They are absolutely ruthless.” That would pale next to the political clout of a big bank that also controlled the mortgage market, and whatever evils grew out of the GSEs’ need to please politicians, there could be worse. Imagine the conversation in a back room between the politicians and the bank executives, where they agree that if the bank will loosen up credit in their states, the politicians will go easy on, say, derivatives regulation. It almost makes the old Fannie and Freddie look pure.

No it doesn’t. And the rest of her piece consists of cheerleading for housing finance subsidies, which is exactly what makes her new book such a disappointment.

Alan Kirman on Hayek

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He says,

he had very clever ideas—but he was extremely bigoted, he was racist. There is a wonderful interview with him that you can find on You Tube, where he says (imitating Hayek’s accent) “I am not a racist! People accuse me of being a racist. Now it’s true that some of the Indian students at the London School of Economics behave in a very nasty way, typical of Indian people…” and he carries on like this. So that’s one reason he is horrid. A second thing is that if you don’t believe he is horrid, David, I will send you his book The Road to Serfdom, which said that if there is any planning going on in the economy, it will inevitably lead you to a fascist situation. When he produced that book it had a big success, particularly in the United States, and what is more, he authorized a comic book version of it, which is absolutely dreadful. One Nobel Prize winner, [Ronald] Coase, said “you are carrying on so much against central planning, you forget that a large part of our economy is actually governed by centrally planned institutions, i.e., big firms, and these big firms are doing exactly what you say they can’t do.

From a new web site called Evonomics, to which Jason Collins contributes. It seems like an eclectic grab-bag of not-necessarily-original content. Worth a visit. For example, in a different piece, Rory Sutherland writes,

The market mechanism is loosely efficient. But the idea that efficiency is the main virtue of free markets is wrong. Competition itself is highly inefficient. In my home town, I can buy food from about eight different places; I’m sure this system could be much more ‘efficient’ if Waitrose, M&S and Lidl were forcibly merged into one huge ‘Great Grocery Hall of The People No. 1306’. I am equally confident that after a few initial years of success, the shop would be terrible.

The missing metric here is semi-random variation. Truly free markets trade efficiency for a costly process of market-tested innovation heavily reliant on dumb luck. The reason this inefficient process is necessary is that, though we pretend otherwise, no one knows anything about anything: most of the achievements of consumer capitalism were never planned; they are explicable only in retrospect, if at all.

Back to Kirman, I found this interesting:

in France when I arrived here it used to take about a day and a half to make my tax return. Now it takes around about 20 minutes, because some sensible guy realized that you could simplify this whole thing and you could put a lot of stuff already into the form which they have received. They have a lot of information from your employer and so forth. They’ve simplified it to a point where it takes me about 20 minutes a year to do my tax return.

Advantage France, apparently.

Overall, you will find the interview annoying. Lots of use of “neoliberalism” and “laissez-faire” as boo-words. Just once, I would like to see someone on the left walk through the Federal Register’s list of regulations and justify the claim that we are living in a laissez-faire economy. And I would like more people to have Sutherland’s understanding of the virtues of markets rather than the neoclassical understanding.

Market Denialism

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Jayson Lusk and Pierre Desrochers write,

In a recent paper, Andrew Zumkehr and Elliott Campbell (2015; Front Ecol Environ 13[5]: 244–248) present a simulation study that assesses the technological feasibility of providing enough local calories to feed every American. In so doing, they suggest turning back the clock on one of Homo sapiens sapiens’ greatest evolutionary achievements: the ability to trade physical goods over increasingly longer distances, producing an attending ever-widening division of labor (Horan et al. 2005). The main benefit of this process is that one hundred people who specialize and engage in trade end up producing and consuming far more than one hundred times what any one individual would achieve on his or her own. By spontaneously relocating food production to regions with higher biotic potential for specific types of crops and livestock in order to optimize the overall use of resources, trade and the division of labor have delivered more output at lower costs.

Pointer from Mark Thoma.

I am stunned by the casual way in which environmentalists dismiss the information that markets provide concerning costs. They instead substitute their own cost estimates.

Some further thoughts:

1. If you really have a better estimate of costs than the market, then there should be profit opportunity. In the case of locavorism, you should be able to offer local food for lower prices. Do any locavorists stop to wonder why food that comes from far away cost less? Do they suppose it is some perverse conspiracy on the part of “big food” to subsidize the transportation industry (or perhaps the other way around)?

2. Consider recycling. At a local elementary school, I saw the winning poster in a county contest to promote recycling. The poster pictured a barren, brown earth, and said that this is what would happen if we did not recycle. And yet, economically, government-forced recycling is unsustainable, and it probably results in a net cost to environmental desiderata. (I wonder if people on the left would be so attached to government-run schools if the propaganda coming from those schools offended them.)

3. Consider two extremes: “free-market fundamentalism,” which says that markets always lead to optimal outcomes; and “market denialism,” which I will define as the belief that the information found in markets is of so little importance that one’s personal opinions should take precedence. I think that in practice market denialism is much more prevalent than free-market fundamentalism. In fact, it is so prevalent that no one refers to it as “market denialism.” They just presume that it is the appropriate point of view.

Related: Clive Crook cites Dani Rodrik‘s 10 commandments for economists.

“Substituting your values for the public’s is an abuse of your expertise.”

Pointer from Tyler Cowen. And how can Rodrik be immune from “abuse of your expertise”?

Schumpeter 1, Galbraith 0

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Mark Perry writes,

In other words, only 12.2% of the Fortune 500 companies in 1955 were still on the list 60 years later in 2015, and nearly 88% of the companies from 1955 have either gone bankrupt, merged with (or were acquired by) another firm, or they still exist but have fallen from the top Fortune 500 companies (ranked by total revenues). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today (e.g. Armstrong Rubber, Cone Mills, Hines Lumber, Pacific Vegetable Oil, and Riegel Textile).

Patterns of sustainable specialization and trade are in constant flux.

Getting Capital Out of the Buggy-Whip Industry

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A commenter writes,

My favorite pet story is the economy is awash in “buggy whip profits”. Many businesses that currently generate free cash flow will be either outsourced or computerized in the future, but it is clear that investment in such firms is not profitable.

This is consistent with the productivity dispersion recently discussed on MRU and also with the large share buybacks made by mature firms.

Because our financial system cannot intermediate these funds towards the really innovative firms, the result is high asset prices and low interest rates.

My thoughts:

1. I love the phrase “buggy whip profits.”

2. There are those who say that the corporate raiding of the 1980s helped move capital out of lazily-managed firms and into better uses.

3. There are those who say that Michael Milken’s junk bonds helped move capital into forward-looking industries, such as the early cell phone networks.

4. As economists, we really do not know much about how financial intermediation works. As you know, I think of households as wanting to hold short-term, riskless assets and firms as wanting to issue long-term, risky liabilities, with intermediaries doing the opposite. But how can we tell if and when there is variation in the ability of the financial system to “intermediate these funds toward really innovative firms”?

Angus Deaton vs. The Representative Agent

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His Nobel citation says,

The insights provided by Deaton’s work on consumption and income have had a lasting influence on
modern macroeconomic research. Previous researchers in macroeconomics, from Keynes onwards, had
relied only on aggregate data. Even if their purpose is to understand relationships at a macro level, today’s
researchers usually start at the individual level and then, with great caution, add together individual
behaviors to compute numbers for the entire economy.

Women Gather, Men Hunt

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Catherine Rampell writes,

But it’s still a bit strange that women are more likely to spend money on ever-rising tuition when they’re not seeing the same financial upside as men.

She goes on to write,

The three fields in which women outnumbered men in the highest numbers are more traditionally utilitarian: health professions (125,000 more women than men), education (61,000) and psychology (60,000).

I am sorry, but psychology is not a utilitarian major. It is a self-indulgent major. There are approximately zero jobs seeking anyone with an undergraduate degree in psychology. Meanwhile, the number of jobs for people with advanced degrees in psychology is very small relative to the number of undergraduate psychology majors, so admission to graduate programs is quite selective.

As for education and allied health professions, I would note that these are occupations that are highly regulated. That is, people with less formal education could do many of these jobs, but they are not allowed to compete for them. They are also fields that strongly resist the concept of merit pay.

Rampell adds,

There are, at least for the time being, lots of decent, middle-class jobs predominantly held by men that don’t require higher education (such as construction and other trades); comparably paying jobs disparately held by less educated women are few and far between.

Females riding garbage trucks are like Black Swans–they may exist but I have never seen one.

A very crude version of evolutionary psychology is that women gather and men hunt. That is, women look for safe and reliable income while men seek income in ways that are more dangerous and can involve extremes of success and failure. I do not think that one should carry this idea too far, but Rampell’s column can be placed in that framework.

Housing Finance Policy and African-Americans

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From The Atlantic:

“Becoming a homeowner was not a fruitful asset accumulation strategy for low- and moderate-income black families in the 2000 decade, in either the short- or medium-term,” write Sandra J. Newman and C. Scott Holupka, authors of a new study from Johns Hopkins University.

…Black families who bought in 2005 lost almost $20,000 of net worth by 2007, according to the paper. By 2011 those losses were more like $30,000. White homeowners didn’t have quite the same problem. Those who purchased in 2007 saw their net worth grow by $18,000 in two years, and then those gains eroded, leaving them with an increase of $13,000 by 2011. All told, the black families lost, on average, 43 percent of their wealth.

…in general black families would have been better off if they hadn’t bought homes at all.

And yet, the advocates of mortgage subsidies and other misguided government housing policies are as active as ever lobbying for more.

Why did the sample of comparable white home owners not do as poorly?

Presumably, the value of their homes declined less. One possibility is that “affordable housing goals” for lenders temporarily increased the prices of homes in black neighborhoods and also created pockets of foreclosures concentrated in those neighborhoods. There are other possibilities, of course.

Thoughts on Inflation

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Scott Sumner writes,

Take a look at the fiscal situation in Europe and Japan, and then the inflation rates in Europe and Japan, if you are still skeptical that monetary policy drives inflation.

My comments:

1. This sounds like a good retort to a view that government deficits determine inflation, because deficits are high in those countries. However, it might also be a retort to the view that money growth determines inflation.

2. I think that you want to hear that “X determines inflation.” The most common view of X is that it is money growth. And when I say that it is not money growth, you want to jump to the conclusion that I must mean that X is the budget deficit. But my troubling answer is that “there is no X.”

3. Prices have meaning in an economy because people expect to wake up tomorrow to find prices very similar to what they find today. Money has value today because people expect money to still have value tomorrow. Thus, I say that money and prices are a consensual hallucination.

4. When have seen money and prices break out of a stable pattern? During hyperinflations, we see governments unable to borrow at reasonable interest rates but still determined to run deficits. Then they print so much money that prices lose their meaning.

5. In general, then there is a regime with very low and stable inflation, and there is another regime with very high and variable inflation, and a necessary condition for the latter is high budget deficits. However it takes more than high budget deficits to get to the high-inflation regime. It takes a deficits that reach a point where the credit markets attach a punitively-high risk premium to the government’s debt.

6. The biggest puzzle for this point of view is an intermediate-inflation case, such as the U.S. in the 1970s. I am left with hand-waving, like saying that wage-price controls created a backlash, where people tried to charge as much as they could, while they could, before they got hit with wage-price controls again. Or the rise in the price of oil created an “inflation psychology.” However, I take a Fischer Black view of monetary policy in that period, which is that money is passively supplied to meet the need for transactions. Remember that the 1970s was also a period in which “money” as we knew it was radically changed by money market funds and the erosion of interest ceilings on deposits.

7. In the 1960s, monetarists wanted to set targets for money growth. Today, there are no money-growth targeters left. That is a tacit admission that there is no reliable relationship between money and other nominal variables.