Government Accounting

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Jason Delisle and Jason Richwine write,

The momentum for fair value accounting is building. The Congressional Budget Office has all but endorsed it, describing fair value as a “more comprehensive” accounting of costs. Scholars with the Federal Reserve, the Financial Economists Roundtable, and the Simpson-Bowles fiscal commission are on board as well. Reps. Paul Ryan and Scott Garrett have championed this issue in the House of Representatives, which passed legislation to put federal loan programs on fair value accounting earlier this year. That vote, however, mostly followed party lines, and the Senate has never advanced similar legislation.

If a private firm accounted for its future obligations the way that the government does, it would be prosecuted. One of the ideas I include in Setting National Economic Priorities (at this point, still vaporware) is government accounting reform.

Sentences I Might Have Written

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A tropical forest is a complex system, but a suburban garden is not. The reason is the the former is deeply interconnected, and it is the interconnected links that define it. A tropical forest will likely collapse if you disturb the natural balance too much, while in a suburban garden you can generally safely remove entire flower beds without affecting its overall health or integrity.

The standard way of doing policy considers our social system as a suburban garden. It tills, plans, and cultivates as if the parts are not interrelated.

That is David Colander and Roland Kupers, writing in Complexity and the Art of Public Policy: Solving Society’s Problems from the Bottom Up.

I am only part way through the book (by the time this post goes up I may be nearly finished). My initial reaction is that it is either more or less Austrian economics. It could be more if I decide that the explicit complexity theory really adds something to what otherwise is a very Austrian critique of mainstream economics. It could be less if I decide that I am disappointed by what I fear will be a treatment of government that I find unsatisfying.

In any case, it looks like one of the better books of 2014. In fact, relative to a very weak 2014 crop, so far this is looking like the best. I first became aware of the book here, but Tyler Cowen never gave it more than an “arrived in my pile” mention, which suggests that he did not find it worthwhile.

Coincidentally, Jason Collins points to an essay by Brian Arthur, who coined the term complexity economics. Arthur also has some sentences that I might have written.

think of the agents in the economy – consumers, firms, banks, investors – as buying and selling, producing, strategizing, and forecasting. From all this behavior markets form, prices form, trading patterns form: aggregate patterns form. Complexity economics asks how individual behaviors in a situation might react to the pattern they together create, and how that pattern would alter itself as a result, causing the agents to react anew.

…It views the economy not as machine-like, perfectly rational, and essentially static, but as organic, always exploring, and always evolving – always constructing itself.

Why Jonathan Gruber is Paid the Big Bucks

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Tyler Cowen comes to his defense.

I’ve disagreed with Gruber from the beginning on health care policy and I thought his ObamaCare comic book did the economics profession — and himself — a disservice. But I’m simply not very interested in his proclamations on tape, which as far as I can tell are mostly correct albeit overly cynical.

My remarks:

1, Gruber is not paid the big bucks to be a political tactician. In particular, whether or not Obamacare was sold deceptively was not his call to make.

2. For me, the problem with democracy is not the intelligence, or alleged lack thereof, among voters. I just think that the wisdom of crowds is channeled more effectively through exit than through voice. As for democracy, it is a good way of arranging for the routine replacement of high-level officials. It is otherwise much over-rated.

3. Gruber is paid the big bucks because he has a quantitative model of how insurance health reforms will play out. Relative to most academic economists and policy makers, my level of trust in such models is rather low. For me, it would be a better world if Gruber and his model were not held in such high regard. But I would have made this point, and probably did so, before the recent controversy.

4. If you need proof of Gruber’s contempt for your intelligence, all you need to do is skim the comic book to which Tyler refers. The comic book left me with the impression that Gruber lives in a Krugmanesque bubble, in which any disagreement must be dismissed as stemming from extreme ignorance and/or evil intent.

5. I think that the extent to which the attacks on Gruber have become personal is something that every economist, regardless of ideology, will come to regret. I am all for criticizing the ideas and the world view that underlie Obamacare. However, a world in which every economist who steps into the policy arena is subjected to opposition research and “gotcha” attacks is not going to be pretty.

Annuities

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Timothy Taylor writes,

Annuities may turn out to be one of those products that people don’t like to buy, but after they have taken the plunge, they are glad that they brought. One can imagine an option where some degree of annuitization of wealth could be built into 401(k) and IRA accounts. For example, it might be that the default option is that 30% of what goes into your 401(k) or IRA goes to a regular annuity that kicks in when you retire, another 20% goes to a longevity annuity that kicks in at age 80, and the other 50% is treated like a current retirement account, where you can access the money pretty much as you desire after retirement. If you wanted to alter those defaults, you could do so. But experience teaches that many people would stick with the default options, just out of sheer inertia–and that many of them would be glad to have some additional annuity income after retirement.

The theory of an annuity is that you insure against the risk of outliving your money. Economists tend to be big fans of annuities, and they view the reluctance of people to buy annuities as a behavioral economics puzzle.

I actually think that it is perfectly rational to shun annuities. My reasons:

1. You are charged more than the actuarially fair premium. Part of that is overhead and profit, and maybe part of that is adverse selection–the insurance company has good reason to fear that you are in better health than someone else your age. In any event, the result is that an annuity reduces your consumption possibilities by as much as would be the case if you over-estimated your lifespan by several years and budgeted accordingly.

2. Taylor notes that

people fear that they might need to make a large expense in the future, perhaps for health care or to help a family member, and if they have annuitized a large share of their retirement wealth they would lose that flexibility.

This is a very reasonable fear. An annuity is risk-reducing if the only risk you face is additional longevity. In fact, other risks may be more serious. You could easily find yourself needing to take out a loan if your savings are tied up in an annuity and your spouse requires a home health aide. (Speaking of which, long-term care insurance is something that I think does make sense, but you should buy it to get through age 75 and then self-insure thereafter).

3. It is reasonable to think in terms of declining consumer expenditures as you age. Will I really spend as much at age 90 as I spend at age 60? Medicare will cover many health expenses, and if I need to spend more of my own money on health care it is likely that I will have much less interest in vacation travel or buying a new car.

4. It is possible to substitute inter-generational insurance. If my mother-in-law had outlived her money, we could have supported her. From our family’s perspective, self-insuring in this way was cheaper than buying an annuity.

Target Bubbles?

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Ian Talley (WSJ) reports,

Financial market risk-taking is reaching excesses comparable to those that precipitated the global financial meltdown, José Viñals said

That is the “top adviser to the International Monetary Fund,” according to the story.

My point is not that I agree or disagree. My point is to note the following:

1. It is easier to picture policy makers doing something about excessive risk taking now, after they have seen what can happen, than in 2006.

2. Nothing is being done about this alleged risk-taking.

3. Therefore, it is very hard to picture policy makers doing something about excessive risk-taking in 2006.

Identifying clear and present financial danger is not as easy as it appears to be in hindsight.

Target the S&P 500?

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Lifted from the comments:

EMH has me puzzled. Since stocks are linked to the economy you must also conclude that long-range predictions of the economy are no better than throwing darts. Yet many economists seem to believe that the Fed could in fact target NGDP and therefore create the economy they want in some respect (obvisously there are plenty of variables they can’t control). Is a variable really efficient if someone can target it?

To put it more simply perhaps, the Fed COULD target the S&P 500 if they wanted to (essentially pick a value). If an entity exists that can control a variable then isn’t it impossible for that variable to be completely unknowable?

1. Long-range predictions of the economy are not much better than throwing darts. Even projections of a year ahead are not much better than just guessing that the real GDP will grow by 2.5 percent.

2. I think that Scott Sumner would say that the Fed could target the level of the S&P 500. That is a nominal variable.

3. However, the Fed cannot target the real return on stocks. If the Fed targets an S&P 500 of 2200 for one year from now, and this is credible, then the S&P 500 has to rise today to the point where the expected real return is comparable to that on other assets.

4. Part of the EMH is that markets anticipate what the Fed will do. So the Fed cannot suddenly surprise markets by targeting an S&P 500 of 2200. If you extend that, you would say that the Fed cannot suddenly surprise markets by targeting a particular level of NGDP.

5. I think there is a bit of tension between believing in the EMH and believing that the Fed can choose any NGDP value it wants. I think Scott is aware of the tension, and I forget how he resolves it.

6. I think that bringing up the stock market is a very good way to raise the issue of whether the Fed can target any nominal variable.

7. Of course, I am not the one who has to defend the proposition that the Fed can target nominal variables. I believe that financial markets can do what they want with asset prices, and that money and prices are consensual hallucinations.

Replace Regulatory Agencies with Simple Laws

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I have talked before about principles-based regulation. I think that one advantage of this approach is that we could get rid of the “fourth branch of government” consisting of regulatory agencies. Instead, regulatory issues would be settled in courts, allowing common law to develop. Violations of the law against taking advantage of consumer ignorance would be punished on the basis of clarity of the violation, severity of the violation, and systematic nature of the violation.

For example, consumer protection could be embodied in a law that says “It is a crime to take advantage of the ignorance of the consumer.”

Let us use as an example a consumer who is obtaining a mortgage. It is easy for the consumer to get ripped off. It is almost impossible to write precise regulations that keep a consumer from getting ripped off. Here is how the law would apply.

How clear is the violation? Ask a juror to say, “If someone I cared about were offered this mortgage, would I want them to take it?” If the answer is “definitely yes,” then there is no violation. If the answer is “definitely no,” than there is a clear violation. If the answer is “maybe, depending on circumstances” or “not too unreasonable” then there is at most a slight violation. And yes, lawyers for each side would be trying to explain to jurors what is or what is not unfair or inappropriate about the mortgage.

How severe is the violation? Back in the day, loan officers would steer a borrower to take a mortgage with an interest rate slightly above what the best rate, because the loan officer would pocket some of the “yield-spread premium.” While this would violate the law, it is not a severe violation, in that it does not cost the borrower much. It is not as bad as foisting a pay-option ARM on someone who only understands the initial monthly payment and does not foresee the future jump in monthly payments. Another measure of severity concerns the vulnerability of the consumer. If we are talking about a financially savvy affluent individual, the violation is less severe than if we are talking about the proverbial poor, trusting widow.

How systematic is the violation? Was pocketing the yield-spread premium an exception to a well-articulated corporate policy. Or were you loan officers trained to extract the maximum yield-spread premium?

What I would like to see happen under principles-based consumer protection is that firms decide to set up internal policies and procedures for designing and marketing products in a fair manner. Instead, under rules-based regulation, the firm focuses on following the rules. This can and does generate a mismatch between the intent of the regulation and the outcome of the regulation.

Comments welcome. I would prefer that you not compare principles-based regulation to rules-based regulation that is perfect in theory. Instead, compare it to rules-based regulation.

Theories of Unemployment

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Stuart Armstrong writes,

The employment market is a market, with the salary being the price. Why doesn’t this market clear? Why doesn’t the price (salary) simply adjust, and then everyone gets a job? It seemed profoundly mysterious that this didn’t happen.

Pointer from “Scott Alexander.”

I commend Armstrong for posing the issue and thinking through it. Everyone who studies economics needs to puzzle it out. However, my viewpoint differs from his.

To me, you have to distinguish real wages from nominal wages. For just a moment, I will play the macro game of treating the economy as a giant GDP factory with identical workers, so I will speak of “the” real wage and “the” nominal wage.

The simplest macro theory of unemployment is that it is due to money illusion. The real wage needs to be lower in order to clear the labor market, but workers will not accept lower nominal wages. Meanwhile, the price level is determined by something else (the money supply, say), so you can be stuck at the wrong real wage. The Keynesian/monetarist cure for this is a higher price level, at which workers are willing to accept the lower real wage that they would not accept previously. It’s the most coherent way to tell the macro story, but it is not very popular. Scott Sumner likes it. I think Bryan Caplan likes it. I think most modern Keynesian macro folks consider it to be too simple.

The theory of unemployment that Robert Solow taught when I was at MIT was from Edmund Malinvaud’s book, The Theory of Unemployment Reconsidered. It did not rely on money illusion. Instead, both wages and prices were sticky. If they both happened to be too high relative to another nominal variable (again, the money supply is a standard candidate), then the demand for goods will be low, and this will reduce the demand for labor. This was called a general disequilibrium model, because it shows how problems in one market can spill over into another market. So, in 2008 there is excess supply in the construction market, and as workers are laid off there they reduce their demand for consumer durable goods, and so you get layoffs there, and so on.

General disequilibrium never really caught on as a story. Instead economists went for the sort of stuff that Stan Fischer and Olivier Blanchard were pushing, which was representative-agent intertemporal optimization with some ad hoc rigidities thrown in. And if you do not know what that means, just suffice to say that Solow and I hated it then and hate it now, while Paul Krugman likes it when it’s used to support Keynesian policies. When it’s used to oppose Keynesian policies, he calls it Dark Age Macro.

The stickiness of “the” price and “the” wage are ad hoc rigidities in the Malinvaud model. To get from there to what I currently believe, you need to incorporate all sorts of other adjustment problems or coordination failures. Imagine the economy being run by a central planner. What does the central planner want to do with those laid-off construction workers, or with the 19-year-olds who took a few courses at community college and then dropped out, or with the 57-year old manufacturing worker whose job was just taken by a robot or by a factory worker in Vietnam?

Substitute for the central planner the set of all entrepreneurs in the economy. Well, it turns out that the entrepreneurs are, collectively, almost as bereft of ideas as the central planner. Meanwhile, the unemployed folks are not so desperate that they go around offering to wash dishes or empty bed pans or do yard work for $5 an hour. Instead, they subsist on savings and handouts from various sources until the set of entrepreneurs figures out something useful for them to do. That is what Tyler Cowen and I started calling the recalculation problem five years ago. It is what I mean when I say that the entrepreneurs have to discover new patterns of sustainable specialization and trade.

In the Malinvaud model, if you could “unstick” wages and prices, you would get out of general disequilibrium. In PSST, it’s probably better to keep prices and wages where they are, so that the existing sustainable patterns of specialization and trade don’t get lost. In order to raise employment, entrepreneurs will have to discover new patterns, and that is a time-consuming, trial-and-error process. Monkeying around with the money supply or the government deficit is not necessarily going to make the process go any faster.