Securitization and Government Backing

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Stephen G. Cecchetti and Kermit L. Schoenholtz write,

That is, only 18% of U.S. securitization – primarily auto loans and credit card debt – are free from government guarantees! Even at the peak of private-sector securitization in mid-2007 – before the financial crisis grew intense – the government-backed share exceeded 60%.

To put these numbers into perspective, we can look at another part of the U.S. financial system: insured bank deposits. You may be surprised to learn that (again, as of end-March 2014) only $6,094 billion out of $9,922 billion in bank deposits are insured. That is, 61% of bank deposits are government backed (see chart below) versus 82% of securitizations.

Pointer from Mark Thoma.

In my view, the political economy of banking works like this:

1. Financial intermediaries want to issue risk-free, short-term liabilities backed by long-term, risky assets.

2. Governments want to allocate credit, both to their own borrowing and to favored constituents.

To accomplish (2), governments guarantee the liabilities of particular financial intermediaries. This in turn allows those intermediaries to accomplish (1).

When government creates agencies, such as the Fed, the FDIC, it does so in the name of financial stability. But you should think of these agencies as tools for credit allocation, not as tools that actually stabilize the financial system.

The Incentive to Invest

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Timothy Taylor writes,

The very slow rebound in investment isn’t obvious to explain.

Read the whole thing. He walks through such explanations as uncertainty, difficulty obtaining financing, low aggregate demand (what Keynesians used to call the Accelerator Effect), and investment that has become less capital-intensive. On the latter, he writes,

it’s often a form of investment that involves reorganizing their firm around new information and communications technology–whether in terms of design, business operation, or far-flung global production networks. As a result, this form of investment doesn’t involve enough demand to push the economy to full employment.

All of these explanations are from a conventional AS-AD perspective. From a PSST perspective, I would look for bottlenecks, particularly in the service sector, where growth is most likely to occur. In the Setting National Economic Priorities Project, the following are considered possible bottlenecks:

–labor-market distortions, including high implicit marginal tax rates embedded in means-tested benefit programs
–the research/FDA approval/patent regime in medicine, given the state of the art in genetics and biochemistry
–the FCC spectrum regime, given the state of the art in spectrum utilization possibilities
–occupational licensing
–regulation of medical practice
–regulation/accreditation barriers to education innovation

The WSJ adds another layer to the mystery.

corporations used almost $600 billion in cash to buy back their own shares in 2013 and the uptrend continues into 2014. While that’s a positive trend for household wealth, it raises questions about companies’ commitment to move ahead with capital spending projects.

Remember the Tobin’s q theory of investment? It says that when stock prices are high relative to the value of existing capital, firms will invest more. Instead, we are seeing firms buy back stock to try to raise q.

This deserves more thought and analysis.

The Incentive to Go Public

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Marc Andreessen says,

The number of public companies in the US has dropped dramatically. And then correspondingly, growth companies go public much later. Microsoft went out at under $1 billion, Facebook went out at $80 billion. Gains from the growth accrue to the private investor, not the public investor.

Pointer from Tyler Cowen.

When you need a lot of physical capital to expand (think of a steel company 100 years ago), you have to offer a high return to public investors. When you can expand by adding more web servers, you might as well keep the company private. Going public does not mean raising funds for expansion. Instead, it just means converting some of your future profits into present cash, courtesy of public investors.

My point is that for information-intensive companies, the balance of power has shifted away from public investors, including large mutual funds, and toward private investors. It may have less to do with Sarbanes-Oxley or other factors that Andreessen cites. The service sector, which is growing as a share of the economy, may be inherently less dependent on outside capital than the goods-producing sector.

By the way, I always thought that Microsoft went public as a political defense strategy. In the absence of political threats, their optimal approach would have been to remain private. But having lots of shareholders gave more people a stake in their success, which helped to reduce the incentive for government predation against them.

Andreessen points out that the stock market has been flat for 15 years. But that takes as your starting point the late stage of the Internet Bubble.

The Internet companies told investors that they were raising money in order to survive without profits while they built up market share. The theory was that network effects and path-dependency were so powerful that once you established your brand you could basically generate profits at will.

We now know that a money-losing online pet store is just a money-losing online pet store, not a future exploiter of network effects and path dependency. To exploit network effects and path dependency, you have to be more like Facebook. But private investors had enough confidence in Facebook to take a large share of its value.

Furthermore, we are now in a world where mobile phones are the leading-edge platform. Who needs to raise hundreds of millions of dollars to create an app?

A Solution to Biomedical Research Incentives?

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I write,

In pharmaceuticals, the challenges with using the patent system are increasing. As Huber has pointed out, the nature of molecular medicine is changing. The system of rigid, blind clinical trials needs to be replaced by a regime of focused trials in which researchers learn and adapt as they go. Medical research may be valuable without producing a brand new molecule that cures a disease and thereby justifies a patent. It may instead focus on determining which combination of drugs will best treat a certain class of patients. A prize-grant would reward this sort of targeted research in a way that a patent cannot.

Brink Lindsey on a Universal Benefit

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He writes,

I think a good case can be made that a UBI [universal basic income] would be more helpful to the disadvantaged than the patchwork of frequently intrusive, infantilizing, bureaucratic, and wasteful means-tested programs that presently constitutes the American social safety net. So if I could wave a magic wand and replace the policy status quo with a UBI, I would do so. That said, my reading of the available evidence convinces me that a social policy that channels benefits through work and thereby encourages paid employment has important advantages over a UBI in helping the disadvantaged to live full, happy, productive, and rewarding lives.

…a UBI cannot be recommended as sound social policy. The great challenge at present is to arrest and reverse the slide of less skilled Americans into a permanent underclass – even as automation and globalization continue to marginalize the role and value of low-skill work. But as the celebrated negative income tax experiments of the late 1960s and early 1970s made clear, unconditional income support reduces labor supply. Perhaps not dramatically, but still the impact is going in the wrong direction. By contrast, wage subsidies in the form of graduated payments to employers of low-skill workers can increase the attractiveness of work and boost labor force participation.

My remarks:

1. I think it is important to distinguish adding a universal benefit to the existing means-tested programs from using it to replace existing means-tested programs. I doubt that the negative income tax experiments give us any idea of how the latter would work, particularly today. (a) I don’t think that the experiments replaced existing programs and (b) today’s programs are much more generous than they were when the experiments were done.

2. Accordingly, I hope Brink would support an effort to wave the magic wand and replace current programs with a universal flexible benefit.

3. Why have wage subsidies on the one hand and payroll taxes on the other? Why not instead introduce a graduated payroll tax, which is lower for low-wage workers, possibly even zero below a certain income level?

4. There are going to be people who simply cannot work. You don’t want to force them to live on minimal resources just because you are afraid of giving other people the incentive to loaf. My solution would be to have the universal flexible benefit, which would come from taxpayers at the national level, provide minimal resources. However, state and local governments as well as charities might supplement these benefits on the basis of needs.

I, Too, Remember the 1970s

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Robert Waldmann writes,

There is a blog discussion among Keynesian to New Keynesian economists on the cause of the new Classical & Rational expectations revolutions. I have been typing my usual comments. I will now try a post. The question is: how important was stagflation in causing the abandonement of old Keynesian models ? I basically agree with Simon Wren-Lewis this time.

On the other hand, Noah Smith writes,

Sure, the old paradigm could explain the 70s, but it didn’t predict it. You can always add some wrinkles after the fact to fit the last Big Thing that happened. When people saw the “Keynsian” economists (a label I’m using for the pre-Lucas aggregate-only modelers) adding what looked like epicycles, they probably did the sensible thing, and narrowed their eyes, and said “Wait sec, you guys are just tacking stuff on to cover up your mistake!” The 70s probably made aggregate-only macro seem like a degenerate research program.

Pointers from Mark Thoma.

Let me try to clear some things up. In some sense, Milton Friedman predicted stagflation in his 1967 Presidential address, but he did not use a New Classical Model. By introducing rational expectations, Lucas produced the New Classical Model.

I want to talk about two stages of “conversion” of mainstream macro. Stage one was the conversion to Milton Friedman’s Presidential Address, delivered in 1967 and published in 1968. Stage two was the conversion from Friedman’s non-rational-expectations version to the New Classical model, which had rational expectations.

Stage one:

–By the mid-1970s, mainstream macro featured a natural rate of unemployment. Before the Great Stagflation, it didn’t.

–By the mid-1970s, mainstream macro featured an equation in which the price level was determined by the money supply. Before the Great Stagflation, it didn’t.

Stage two took over graduate macro without really penetrating freshman macro. It changed from Friedman’s story, which implicitly used backward-looking expectations, to Lucas’ model, which used forward-looking expectations.

In my view, there was no empirical event that drove the stage two conversion. That is, there was nothing that took place in the 1970s that required a rational-expectations explanation. You could predict stagflation just using Friedman’s model with backward-looking expectations. So maybe I am agreeing here with Wren-Lewis rather than with Smith, or maybe I am disagreeing a tad with both.

In my view, what drove stage two was (a) the inconsistency between believing in the paradigm of rational agents and believing in backward-looking expectations and (b) the aura of mathematical superiority that was associated with rational expectations modeling. Honestly, I think that (b) had a lot to do with it.

My macro memoir blames Stan Fischer at MIT for a lot of (b).

Do Short-Sales Costs Matter?

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Noah Smith says that they do.

So in the equity market, shorts face huge disincentives, and longs don’t. That means over-optimistic longs get to set the price.

I am skeptical. Financial markets tend to find a way to work around barriers. For example, on alternative to shorting a stock is to buy a put option and write a call option.

Corporate Profits and Stock Prices

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Scott Sumner is suspicious.

Here is the evolution of labor compensation and corporate after-tax profits over the past 9 quarters:

Total labor compensation: $8315.3b. —-> $9049.5b. Up 8.8%

After-tax corporate profits: $1184.6b. —-> $1099.5b. Down 7.2%

…I know of no other data confirming that plunge. Stock prices are soaring. Corporations have been reporting very strong earnings. If someone can find non-government data supporting the claim that workers are far outperforming corporations in recent years, I’d love to see the evidence.

Robert Shiller tracks the data for the S&P 500. His earnings measure only goes through the end of 2013. From December 2011 to December 2013, he shows the S&P 500 up 45 %, dividends up 32 percent, and earnings up 15 percent. Since then, stock prices have gone up more than 5 percent, so if profits truly took a dive then the market is doing a great job of ignoring it.

We are going to see some upward revisions in Commerce Department data for corporate profits or some downward adjustment in stock prices. Personally, I expect to see some of both.

Ralph Nader’s Worldview

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From an interview with Tyler Cowen.

If you look at the history of nations, major redirections for justice were brought about by never more than 1 percent of the active citizenry. Whether it was civil rights, the environment, or consumer protection, they had one asset: They represented what Abraham Lincoln called the “public sentiment.” Nowadays people give up on themselves and rationalize their own powerlessness, but it takes very few people in congressional districts and around the country to make major, long-overdue changes in American society that are supported by large numbers of people.

In other words, the Ralph Naders of the world are the heroes. People with great moral vision who use the forces of activism and government to overcome the evils of the private sector.

Unfortunately, what is required to become a Ralph Nader is an unshakable belief in your own righteousness and in the wrongheadedness of those with whom you disagree. Tyler tries to get Nader to admit that he has gotten something wrong, and all Nader can come with is

I underestimated the power of corporations to crumble the countervailing force we call government.

To me, Nader’s absolute certainty about his own righteousness makes the whole idea of an alliance involving him untenable. If you are that certain of yourself, then you cannot accept other people on equal terms. Working with him cannot involve give-and-take. It has to be obedience.

Larry Summers on SecStag

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He writes,

With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors. As such, one would expect greater reliance on Ponzi
finance and increased financial instability.

Pointer from Tyler Cowen.

Larry thinks that if the government spends more money, it will work on improving JFK airport. If government does not spend more, then the private sector will take crazy risks.

I mean, if you think that government spends money wisely and the private sector does not, you do not need a whole theory of secular stagnation. To me, it looks like an opinion masquerading as a theory.

Maybe I am being too grumpy. The actual grumpy economist™, John Cochrane, has this to say.

The natural rate is per Laubach and Williams, about -0.5%. But we still have 2% inflation, so the actual real interest rate is -1.5%, well above -0.5%. With 2% inflation, we need something like a 4-5% negative “natural rate” to cause a serious zero bound problem. While Summers’ discussion points to low interest rates, it is awfully hard to get any sensible economic model that has a sharply negative long run real rate.

And he adds this:

From my point of view, the focus on and evident emptiness of the “demand” solution — its reliance on magic — just emphasizes where the real hard problems are.