Economist Channel

Justin Baer and Ryan Tracy have an excellent article in the Wall Street Journal commemorating the tenth anniversary of the Bear Stearns bailout.

The Federal Reserve tried to limit the damage with extraordinary actions, first extending the firm credit before forcing it into a hasty weekend shotgun marriage to JPMorgan Chase with $29 billion in assistance.

More specifically,

Ten years ago, Bear’s crisis week began with rumors of liquidity problems following steep losses from mortgage bonds. Mr. Schwartz, the CEO, phoned JPMorgan Chief Executive James Dimon to ask for a simple overnight loan. By that Thursday, Bear’s lenders and clients had backed away, and the firm was running out of cash. Mr. Schwartz called Mr. Geithner for more help.

Fearing a Bear-induced panic could spread throughout the banking system, the Fed arranged a $12.9 billion emergency loan routed through JPMorgan. It ultimately agreed to purchase $29.97 billion in toxic Bear assets.

First, Bear lost a lot of money in mortgage backed securities. Second, like Lehman to follow, Bear was mostly financing that investment with borrowed money, and short-term borrowed money at that, not with its own money, i.e. equity capital. Small losses then made it more likely Bear would not be able to pay back its debtors. Third, there was a run.  Short term creditors ran out the doors just like Jimmy Stewart's depositors in a Wonderful Life. More interestingly, Bear's broker-dealer clients started running too. Just how investment banks like Bear were using their broker-dealer clients to fund investments is a great lesson of the event.  Darrell Duffie lays this out beautifully in The failure mechanics of dealer banks and later How big banks fail.


So, if you want to stop a run, you need to convince creditors that their money is safe. Usually, you do that by issuing more equity, "recapitalization,'' But at this point, new equity holders understand that most of their money will go to pay off creditors who otherwise aren't getting anything, "debt overhang." So we need to find a source of new equity for whom the firm will be valuable enough that it's worth paying off the creditors to get it. That's the idea of one of these last minute sales to another firm, JP Morgan.

In this case, that failed too. There wasn't enough value in the firm left. It took $29 billion more to give the appearance of a buyout which would keep Bear going as part of JP Morgan, and more importantly to pay off the creditors. (That word "reacapitalization" more and more in the passive voice, tends to mean money from the government.)

Bailouts are not of the company or the management. It is all about making sure creditors get paid, so they don't run. Bailouts are always creditor bailouts.

Needless to say, this bailout did not in the end stop the financial crisis, and $29 billion would soon seem like couch change.

So, where are we now?

"Key players in the bailout, many of whom remain in finance, have spent the last decade arguing about what was done, defending decisions made then and wondering whether it could happen again. The consensus: It would be unlikely for another big firm to get into such trouble, or for the government to orchestrate such a bailout"

I found this interesting, especially the last statement. For the other universally held truth (false in my view, but I'm a tiny minority) is that letting Lehman go under was a huge mistake and led to the financial crisis. If only the Fed had saved Lehman as it did Bear, the story goes, things would not have been so bad. So why would the government not orchestrate a bailout?

"Veteran Wall Street lawyer Rodgin Cohen, who helped shape the deal for Bear Stearns, says that if a crippled firm were on the brink today, none of its peers would arrive with a rescue. “Nobody will ever again buy a severely troubled institution,” he says. “Period.”"

Many officials in Washington feel another bailout is just as unlikely. 

Why not?

The first line of defense has always been one of these arranged last-minute marriages, in which a healthier firm takes over a failing one. This will not happen again.

Nearly everyone in charge on Wall Street today, including JPMorgan’s Mr. Dimon, says they would never buy a collapsing firm like Bear.

“No, we would not do something like Bear Stearns again—in fact, I don’t think our board would let me take the call,” Mr. Dimon wrote in his 2014 letter to shareholders. “These are expensive lessons I will not forget.”

In addition to the cost of bringing the two firms together, JPMorgan was saddled with billions of dollars in legal bills and regulatory penalties. Months after the Bear deal, JPMorgan made a similar last-minute agreement to buy Washington Mutual Inc. Of JPMorgan’s nearly $19 billion in legal costs from the mortgage crisis, some 70% stemmed from Bear and WaMu, Mr. Dimon wrote.

There were many other such deals in 2008. Wells Fargo & Co. bought Wachovia Corp., Bank of America Corp. acquired Merrill Lynch & Co. and Countrywide Financial Corp., and Toronto-Dominion Bank bought Commerce Bancorp. Today, many of these Wall Street executives say they feel betrayed by the government for hitting them with penalties tied to actions by firms they were pressured to acquire.

These days, a big financial firm rescuing another would also have to consider new restrictions on risk-taking. Banks today must pass regulatory tests before paying out profits to shareholders. In that environment, executives may be more reluctant to buy assets from a desperate seller. 

Loud and clear. Over and over, the government asks a big bank to help out by taking over a failing bank, which means agreeing to pay all that failing bank's debts.  But this time, after the fact, the government made the new owners pay billions in fines for the old company's debts. Take my trash out, asks your neighbor, and you say "sure," then he calls the EPA to report on the toxic waste now in your trash barrel. Not again. And if that weren't enough, the government's own regulations will prohibit it.

So if a bailout is needed, private help won't be there.

Well, what about government help? We got $700 billion of that too last time.

Fed help like that would be illegal today. The 2010 Dodd-Frank financial-regulation law stipulates that emergency Fed lending must be “broad-based” and cannot be “established for the purpose of assisting a single and specific company.” Financial firms, like other corporations, are supposed to go bankrupt, not get bailed out.

So what is supposed to happen? "Orderly liquidation."

If regulators and the Treasury secretary assert a bankruptcy would destabilize the financial system, Dodd-Frank provides a new backstop called the Orderly Liquidation Authority. The government would take over the failing firm, wiping out shareholders. After a weekend of work by federal officials, a new company, owned by creditors of the old firm, would open Monday morning. The government would be able lend money to the new company to keep the lights on while the government sells it off in pieces.

That is supposed to prevent a panic because people who had been doing business with the failing firm would know they could continue to do so, at least for a while.

In sum, the lifejackets (shotgun marriages) and lifeboats (government bailouts), distasteful as they are, are likely gone. Speedy bankruptcy isn't here yet. We are relying on a new and untested idea, the watertight compartments.

I have long been suspicious of "orderly liquidation." The whole premise is that big banks are too complicated to go through bankruptcy court. So, the Treasury Secretary, Fed Chair and a few other officials are going to figure out who gets what over a weekend? What would you do if a big bank owed you a few billions, was on the brink, and you suspected these fine officials would be meeting this weekend to divvy up the carcass? How about run now?

What if orderly liquidation doesn’t prevent a panic? In a crisis, problems at one firm can lead investors to “run” to cut their exposures everywhere. Even healthy companies can’t get credit, damaging Main Street as badly as Wall Street. In that scenario, there may be little U.S. regulators can do on their own. Congress might be asked to reinstate the bailout authority it took away after 2008.

“Drafting big books, massive documents, having big teams—that’s all a good idea,” says Gary Parr, a longtime deal maker who advised Bear on its sale to JPMorgan. “But when you have a company get into a liquidity crunch, if things are going really fast, you don’t have time to study a book.”

The best of all worlds is one in which nobody expects a bailout, it comes once to stop a run, and then we put the moral hazard genie back in the bottle. The worst of all worlds is one in which everyone expects a bailout, but then either by legal restriction or decision it does not come. Nobody has fire extinguishers any more, and the fire house has burned down.

Where will the next crisis come from? It always comes from a new and unexpected source, so don't plan on subprime mortgages funneled through investment banks. Look instead and ask, where is there a mountain of debt that can't be paid back, a bunch of really obscure accounting, off the books credit guarantees? China's great wall of debt suggests one answer.

The other worry  " Congress might be asked to reinstate the bailout authority it took away after 2008." Yes, but even that was authority to use borrowed money. The last crisis cost us something like $5 to $10 trillion. If the US asks for that much money again, can we get it?

But all of this ignores the basic point. Financial crises are not about the failure of specific institutions. Financial crises are about runs. One way to stop runs is to convince short term creditors that no institution will ever lose money again, or that there is a big bailout ready. The other way is to fund risky investments with lots more equity. Not to beat a dead horse over and over again, but the real lesson of Bear Stearns and Lehman is what happens if you fund  risky investments with a huge amount of short term debt. That can be fixed.

(Actually, subprime mortgages aren't even very risky. Google's self driving car is way more risky. All corporate cashflows are way more risky. Why are we spending all this money policing pools of mortgages, about the safest asset there is? Answer, because they are funded by huge amounts of run-prone short-term debt.)

Two bits from Marginal Revolution on truck automation are so good they merit passing on here. Dan Hanson writes this amazing comment

I wonder how many of the people making predictions about the future of truck drivers have ever ridden with one to see what they do?

One of the big failings of high-level analyses of future trends is that in general they either ignore or seriously underestimate the complexity of the job at a detailed level. Lots of jobs look simple or rote from a think tank or government office, but turn out to be quite complex when you dive into the details.

For example, truck drivers don’t just drive trucks. They also secure loads, including determining what to load first and last and how to tie it all down securely. They act as agents for the trunking company. They verify that what they are picking up is what is on the manifest. They are the early warning system for vehicle maintenance. They deal with the government and others at weighing stations. When sleeping in the cab, they act as security for the load. If the vehicle breaks down, they set up road flares and contact authorities. If the vehicle doesn’t handle correctly, the driver has to stop and analyze what’s wrong – blown tire, shifting load, whatever.

In addition, many truckers are sole proprietors who own their own trucks. This means they also do all the bookwork, preventative maintenance, taxes, etc. These people have local knowledge that is not easily transferable. They know the quirks of the routes, they have relationships with customers, they learn how best to navigate through certain areas, they understand how to optimize by splitting loads or arranging for return loads at their destination, etc. They also learn which customers pay promptly, which ones provide their loads in a way that’s easy to get on the truck, which ones generally have their paperwork in order, etc. Loading docks are not all equal. Some are very ad-hoc and require serious judgement to be able to manoever large trucks around them. Never underestimate the importance of local knowledge.

... a fundamentally Hayekian insight: When it comes to large scale activities, nothing about change is easy, and top-down change generally fails...

I would add silicon valley software companies, and media commentators to the think tanks and government offices, on the list of pundits that tend to denigrate the skill, knowledge and intelligence required of what are very wrongly call "low skilled" jobs. I note several times the "paperwork" required in trucking as well.

The comment was on an earlier MR post covering Alexis Madrigal in the Atlantic on self-driving trucks. Automation in any industry reduces costs and increases quality. These mean the industry expands, so labor demand may even grow. Think of the computer you're reading this on. Labor gets to specialize at the things people are good at, which is higher productivity, and wages rise.

Uber does not believe that self-driving trucks will be doing “dock to dock” runs for a very long time. They see a future in which self-driving trucks drive highway miles between what they call transfer hubs, where human drivers will take over for the last miles through complex urban and industrial terrain.

And fill out that paperwork.

if the self-driving trucks are used far more efficiently, it would drive down the cost of freight, which would stimulate demand, leading to more business. And, if more freight is out on the roads, and humans are required to run it around local areas, then there will be a greater, not lesser, need for truck drivers. 

The article misses the second, more important effect. As low-cost trucking expands, other businesses that use trucks expand, and they hire people too.

And I just googled "truck driver shortage" to get the latest media story to rediscover this fact. From NPR "Trucking Industry Struggles With Growing Driver Shortage",

The trucking industry is facing a growing shortage of drivers that is pushing some retailers to delay nonessential shipments or pay high prices to get their goods delivered on time.

A report from the American Trucking Associations says more than 70 percent of goods consumed in the U.S. are moved by truck, but the industry needs to hire almost 900,000 more drivers to meet rising demand.

It's a tough job.  Young people aren't going in to it. There are competing opportunities. My last Uber driver just quit long-haul truck driving. He earns a bit less, but gets to see his family every night.

(Of course we don't use the word "shortage" in economics unless there is a government-imposed price control. This just means wages will go up.)

Update: Thanks to the comment from Unknown below, here is the response from Tom T in MRs comments

This comment reminds me of the guy in Office Space who ends up helplessly screaming at the downsizing consultants, “I have people skills!”

It’s trying way too hard. Sure, the truckers do all of these things. But is there any reason to think that the self-driving AI won’t be just as good, if not far better, at confirming that the load is secure, verifying the manifest, monitoring vehicle maintenance, and interfacing with the weigh station? Does anyone really think a computer can’t split loads and optimize returns? Even accepting the dubious premise that the poor driver is somehow providing effective security by sleeping in the cab in front of the load, the whole need for that sleep-time security disappears when the vehicle is self-driving and doesn’t have to sleep. Truckers who are self-employed and have to do bookwork, taxes, and customer relationships will have a lot more time to devote to that end of the operations if they don’t also have to drive the truck. Loading docks that are ad hoc will find themselves either standardizing or paying extra for failing to do so, like every other aspect of an industrial, computerized world.

I’ve been a litigator for 25 years. At one time, we saw our profession as so paper-based and quirky and fact-dependent that it would always be safe from automation. Sure enough, OCR text recognition, keyword searches, and predictive algorithms completely changed the economics of document review. No one is immune from automation.

I heard somewhere, I forget where, the quip that the ones who really should fear automation are accountants, book keepers, and other fairly routine paperwork office workers. It sounds awfully sensible. Of course our government is pretty good at expanding the demand for paperwork!

China builds a railway station in 9 hours (HT Marginal Revolution).

Yes, it's basically a propaganda video, but interesting nonetheless as a reflection on infrastructure.  The video does not say how long China spent on environmental review -- did it disturb wetlands, threaten various species, what's it's carbon footprint -- legal review -- is it paying prevalining union wages, was it bid with proper female and minority headed construction company set asides -- did it have community input, consistency with planning targets and so on. I doubt it was the oh, 10 years or so that takes in the US.

To be clear, I am not saying all that is useless. China has awful pollution,  and our reviews accomplish something.  China doesn't bother with the niceties of private property ownership, eminent domain proceedings, and legal challenges when they want to build a railway. These don't just triple or more the cost of projects, send vast sums of money to well-connected companies and lawyers and lobbyists, and delay projects for decades. But they also have that effect.

It's also interesting as a pin factory visit.  With that many people on a job, I would have thought they would be getting in each other's way. This video seems to deny the Q theory of investment! Some are standing, but a remarkable number are working hard. Of course, the video is edited.

When I watch US infrastructure projects, I see a lot of people standing around or "supervising" the one poor sob who is actually doing the work. That ratio seems a lot lower here.

There are a lot of machines.  The days of China substituting lots and lots of labor for capital are gone. The Chinese have taken Milton Friedman's advice. (On a visit to a dam, Friedman noticed people using shovels. He asked why they didn't use bulldozers. The answer was to give more people employment. Friedman responded, why then don't you make them use spoons?) This is not a new observation, but the video is a good reminder from afar.

The tariff and the wall were the big news this week, with some lessons for looming infrastructure.

The Tariff

30% on solar cells, 20-50% on washing machines. Since the ill effects of tariffs have been know for, oh, about 250 years, said again eloquently by the Wall Street Journal in Trump starts his trade war,  Let me try to offer some comments beyond the usual economist response -- comparative advantage, trade must balance, follow the money anything that goes overseas must come back, imported products are inputs too, solar cell installers need jobs too, blahdah blahdah blahdah.

Washing machines, a device unknown to the inside the beltway types, is how the rest of us clean clothes. So raising the price of washing machines is one more little sucker punch to people who wash their own clothes.

Solar panels are supposed to save the planet. Our government already subsidizes them heavily via tax deductions, credits, Solyndras, renewable mandates, and so on, with the purpose of lowering carbon emissions. If that is the purpose, then we want the cheapest panels around to compete with fossil fuels. If that means made in Malaysia, great. The planet does not care where they are made.

If the Chinese government wants to tax its citizens to send us artificially cheap solar panels, we should thank them for their generosity in helping us to save the planet. It's absolutely hilarious to see complaints that China is subsidizing its solar cell industry so merits retaliation, given how much subsidy they receive here.

Yet even Al Gore agrees that the tariff is a good idea and wants solar cells made in the US.

What's going on? I think there is a good lesson in political economy. Once a government starts subsidizing something, everyone lines up at the trough. If taxpayers are going to be on the hook, then every interest wants its share. So potentially sensible carbon policy ends up as one more boondoggle.

Related, this week I saw the brilliant post Solar panels cost twice as much to install in the US as in Australia. (HT marginal revolution.) The answer, as usual in what Mark Steyn calls the Republic of Paperwork, is the paperwork.

I loved the flowchart on what it takes to get solar installed. In particular, you see here a real person who has really done it. The rules just say ``get a permit'' but the actual process, laid out in the picture, takes many trips back and forth and negotiations with the permit granters, all on someone's paid time.


This is a lovely detailed example of a larger question -- just what is the cost of regulation? I've been having this back and forth with some liberal economist friends, who pooh pooh the idea that regulations cost a lot. And here the official paperwork act disclosures, pages of the federal register, and so on would not add up to much. Yet, it does add up, to double. And installing residential solar is pretty simple, and something governments say they want. If this example scales, than GDP is half what it could be with a simper regulatory system.

Back to tariffs. Just why is it so hard to grasp that tariffs are a bad idea? Well, it must be because it is hard, and illustrates perhaps why economics really is useful, and why "business experience" is not generally a good qualification for policy. Anything that reduces competition and drives prices up is good for an individual business. Business leaders know this. Take that business leader to Washington and he or she will quickly conclude that what's good for my business is good for yours. A tariff on everything! Reduce harmful competition everywhere! We call it the fallacy of composition. What is good for one business is not good for all businesses, because that one business is profiting at the expense of everyone else. Business or banking experience does not generalize to good policy.

(Update:) But it's not just the administration that is to blame. The trade law that the administration applies specifies that tariffs are to be imposed if  domestic companies are hurt by imports. That's an absurd blatantly protectionist standard. We have relied for years on the trust that  administrations would not be so stupid as to actually enforce the law as written."Well, if one comes along that is, perhaps it's time to rewrite the law. If the law said only that tariffs are imposed if american consumers are hurt by imports, or even the american economy as a whole is hurt by imports, much of this mischief would go away.

Congress can, and should fix this. Perhaps as with DACA, the Trump Administration actually executing the law as written by Congress will spur Congress to fix its absurd law. Get rid of the Jones act (all shipments to/from American ports on US built, operated, and staffed ships) while you're at it.

The Wall and infrastructure

A deal seems to be emerging, one that I advanced almost as a joke at faculty lunches. But it may happen. Give him his Wall, and get pretty much whatever you want in return.

From Trump's immigration offer

White House floated a proposal on Capitol Hill late Thursday that would offer legalization and a path to citizenship for some 800,000 so-called Dreamers in return for funding for President Trump’s wall at the Mexico-U.S. border and other changes to U.S. immigration law.

And arguments for taking the offer. From William A. Galston (One of WSJ's liberals)

In all, only 37% of Americans think adding a substantially expanded wall on the southern border is a good idea. But we have reached a point at which the sentiments of the majority are politically secondary. It is unimaginable that Mr. Trump will break faith with his supporters on this matter. Any deal, broad or narrow, will have to acknowledge this reality.

Such is infrastructure in the US today.

Can you imagine what will happen with the Wall, even if Congress appropriates $25 billion? It will instantly be in court. Start with environmental challenges. It will of course interrupt the migration path of the Eastern Arizona accelerati incredibilus. It will disrupt holy native lands and archeological sites. Mexicans are largely catholic, so suits will claim the wall is religious discrimination. Heck, infrastructure has to pass cost benefit tests, and good luck with that one.  The contracting was improperly done. State attorney generals busy suing the Trump administration will quickly add to this one.

As with solar cells, as with the second avenue subway, as with the high speed train, as with the Keystone pipeline, good luck building any infrastructure in America today -- and especially good luck building one that makes little sense and is a highly politicized hot potato.

If they gave the President all he wanted, tomorrow, this thing would not be out of court for decades, long after a democratic congress or administration kills it.

They can afford to give him a symbolic victory. If, well, they decide that they can afford politically to give him a symbolic victory. For that is all it will ever be. And frankly, even $25 billion of waste to fix immigration would not be a bad tradeoff. The waste to our country in the current immigration system is on the back of my envelope orders of magnitude greater than that.

Looking forward to infrastructure. 

As reported in the Wall Street Journal

U.S. Chamber of Commerce President Thomas Donohue last week was nearing the end of a speech urging Congress to rebuild the nation’s infrastructure when he offered another option: At least make it easier to build things when the money can be found.

“If we just fix the permitting thing this year, you would create an extraordinary enthusiasm about moving forward,” Mr. Donohue said,  

...Mr. Trump and his aides have cited studies suggesting that environmental review can often take a decade,  

 A Government Accountability Office study of the environmental review process in 2014 cited third-party estimates that reviews average 4.6 years. Outside experts say actual review times vary widely based on the scope of a project and other environmental factors.

If the average review time for, I guess, building a freeway cloverleaf, is 4.6 years, and often takes a decade, this makes my point -- don't worry about the wall!

The point of the article was that the Administration would like this to be reduced to two years. Good luck with that. The other point of the article is environmental groups lining up to fight any streamlining of the permitting process. Strategic delay rather than policy outcome is vital to them, apparently.

But the administration is right. If infrastructure is going to be built in the US, it strikes me that reforming the process for building infrastructure is the key. If home zoning and inspection requirements double the cost of residential solar cells, if prevailing wage, union work rules, and a hundred other impediments mean that subways cost billions of dollars per mile, many multiples of what they cost in France let alone China, and if permits take decades, and billions more of consultant and legal work, our problem with infrastructure is not finding the money to pay for it.

In the meantime, I offer a final suggestion to the Trump team: Offer to build a high speed train along the border instead! Just forget to put in any crossings.

(Update: I am just now reminded by a story on NPR that President Trump had, as a candidate, suggested coating the wall in solar cells. Truth is stranger than fiction.)

The High Cost of Good Intentions is a superb new book by my Hoover colleague John Cogan. It is a political and budgetary history of U.S. Federal entitlement programs. It is full of lessons for just why the programs have expanded inexorably over time, and just how hard it will be for our political system to reform them.

If indeed the Congress will now turn to entitlement reform, as house speaker Paul Ryan has promised, this will be the book to have on your desk. (Ryan already blurbed it (back cover) as did Bill Bradley, Sam Nunn, George Shultz and Alan Greenspan.)

If you think entitlement programs, and the political hash that enacts them, are recent problems, or the fault of one political party, think again. John's main lesson is that the emergence of bloated entitlements is a hardy feature of our (and many other countries') democracies.  He does this by just reading the history.

The habit of expanding entitlements started early. Chapter 2:

Revolutionary War pensions were the nation's first entitlement program. ... between 1789 and 1793, the federal government agreed to pay annual pensions to Continental Army soldiers and seamen who became disabled as a result of wartime injuries or illness. [later, as an inducement to service]... 

For forty years, Congress enlarged and expnaded these benefits until, by the 1830s, they covered virtually all Revolutionary War seamen and soldiers, including volunteers and members of the state militia and their widows, regardless of disability or income. 

That costs might balloon beyond forecasts was not a total surprise

Opponents of the 1818 law predicted that granting lifetime pensions to Revolutionary War veterans who were "in reduced circumstances" would be costly. Senator Nathaniel Macon of North Carolina observed, "Pensions in all countries begin on a small scale and are at first generally granted on proper consideration, an that they increase till at last they are granted as often on whim or caprice...[it] will on experiment, be found an endless task. It will drain any treasury, no matter how full." 

Yet, the service pension law of 1818, which granted such pensions to all revolutionary war veterans who were "in reduced circumstances"

produced a massive surge in applications and an unexpected and unprecedented cost to the Treasury. The law's proponents had estimated that fewer than two thousand veterans would qualify and that the annual cost might reach $115,000. But by the end of 1819, more than twenty-eight thousand individuals had applied... The 1818 law's annual cost to the Treasury had ballooned from $300,000 to a staggering $1.8 million. ..widespread charges of pension fraud and corruption. A law designed to assist destitute veterans was providing pensions to many financially well-off veterans and even many who had never fought for the nation's independence. 

...Congress's underestimate of the cost was on the first of many underestimates. These miscalculations are invariably due to Congress's failure to appreciate how an offer of entitlement assistance can cause individuals to change their circumstances to qualify for aid they have previously managed to live without. 

This is a familiar theme in entitlement programs, but just how far back it goes was news to me.

A bigger theme of the book is the politics of entitlements. That also starts long ago. Congressman Dudley Marvin of New York reports

"In the villages in his part of the country, when the semi-annual pay day arrived, they [pensioners] were in the habit of forming themselves into companies, then forming a column and thus marching to receive their quota of the public bounty" 

This spectacle served as an early hint of the sense of entitlement that can affect groups of recipients of public assistance... such groups can develop an expectation that society owes them benefits that initially were bestowed out of gratitude for military service or a desire to alleviate hardship. We will observe this expectation and the sometimes remarkable behavior it generates in later chapters on twentieth-century entitlements. 

For example, a century later, the linkage between individual payroll taxes and benefits was crucial to the "enactment, long-run endurance, and, ultimately high cost" of Social Secrurity

Paying payroll taxes gave [gives!] program participants a sense that by contributing to the program during their working years, they were establishing an earned right to benefits when they retired. ... Senate Finance Committee chairman Walter George noted" Social security is not a handout; it is not a charity; it is not relief. It is an earned right based upon the contributions and earnings of the individual.  

When [President Roosevelt] was challenged about financing Social Security with a regressive payroll tax rather than general fund revenues from the progressive income tax, he replied, "We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program. Those taxes aren't a matter of economics, they're straight politics" 

Civil war pensions followed the same path, on a larger scale

The civil war pension program began with the same high-mihnded, noble, and limited goal as Revolutionary War pensons: to compensate soldiers for the loss of life and limb suffered in wartime service to their country... A half-century later the program evolved into a general disability and retirement program for virtually all Union soldiers...Congress also eventually stretched eligibility for pensions to virtually all widows and survivors of union soldiers, even those who had married many decades after the war had ended..

Costs ballooned, for example on the 1879 arrears law, that allowed soldiers to file disability claims after the original deadlines

The bill's senate floor manager, Sentaor John Ingalls, had put the total at $18 to $20 million. Hayes administration officials estimated a much higher cost of between $50 and $150 million. ... Two years after the law's passage President Chester A. Arthur reported that arrears payments had already cost taxpayers $235 million...It is fair to conclude that the law added nearly $400 million to pension expenditures during the 1880s alone  

New interest and lobbying groups emerged

claims agents led the advocates for arrears payments. These agents, certified by the pensions office, assisted veterans and widows with the complex application process, represented claimants in appeals before the pension office, and received compensation for their services. ... claims' agents had emerged as a powerful lobbying force. 

... The arrears act also spawned a second large national lobbying force: The Grand Army of the Republic (GAR). The GAR's evolution from a service organization ta special interest lobby..would be followed time and again by twentieth-centry lobby groups...

At this time, politicians discovered how important entitlements could be to electoral success, beginning the mad use of public money to buy votes that we see today.

The (1884) election campaign witnessed the use of the Pension office as a political machine to gain partisan advantage. (good story follows) 

... Along with this legislation came an important and powerful discovery by the Congress and the executive branch: broadly distributing cash benefits directly to a large segment of the voting population could produce significant electoral advantages. 

The story repeats again with WWI veterans.

There are occasional retrenchments and reforms, especially useful to ponder now.

Candidate Cleveland renewed his previous campaign promise to `cleanse the pension rolls and limit ... benefits to 'worthy' veterans. ...Voter backlash against the tariff and pension corruption contributed to President Cleveland's landslide victory.... Cleveland took immediate actions... The GAR rallied against this minor reform as if the pension rolls had been purged, decrying "false economy which shaves and pares to the quick at the expense of honor, justice and principle." ... by the time Preisdent Cleveland left office in 18997, there were 12,500 more Civil war pensioners than when he had taken office. 

Interestingly, Franklin Roosevelt was a great enemy of large veteran benefits. Roosevelt

shared the founding fathers' belief that all citizens had an obligation to serve their country in wartime, and therefore did not represent a special class of individuals entitled to government benefits merely because they had served during wartime. .. His views were decidedly at odds with Congress, which invariably concluded that all wartime veterans, especially when they reached old age, stood as a special class. 

 Roosevelt also thought balanced budgets were important. He acted cleverly:

On Sunday night, the President gave the first of his legendary fireside chats, reassuring the public that the US banking system was in should shape. On Monday he sent to Congress his third message: to modify the Volstead Act to permit the sale of beer... an extremely popular proposal. Now the Senate was in a bind. Under Senate rules, action on the Volstead act could not take place until the Economy act had been addressed... 

and they passed it

The law repealed all entitlements to pensions that had been granted to veterans of World War I, the Spanish American War, the Boxer Rebellion and the Philippine insurrection.. For the first [last?] time in US history, a large-scale entitlement had been repealed. ... 

Several factors account for President Roosevelt's remarkable success in reducing veteran's pensions. The economy and federal budget's dire situation presented the president with a national emergency, and in Washington such emergencies are a strong predicate for action.. President Roosevelt was also willing to use his veto power to sustain his policies... 

Roosevelt's attitude to veterans did not last.

*****

I'm up to the beginning, really, of the book, "The birth of the modern entitlement state." The centerpiece of the book is not these historical antecedents, but the political story of how the current US entitlements system evolved.

That story starts with the New Deal. It also brings in the judiciary, the "role of the federal courts in making public policy:"

The new Deal entitlements ushered in a new era for the federal courts. ... once federal entitlement rights had been granted, the nature and extent of these legal right had to be adjudicated....In the 1960s and 1970s, the federal courts .. expanded[ed] the legal rights of entitlement claimants in welfare, health care, and nutrition. Ultimately federal court decisions created welfare entitlement right where none had been legislated. 

There are many more themes worth stressing, even in the ancient history, and I won't prolong the quotes delicious as they are.

One theme: Our government routinely liberalizes entitlements when budget surpluses are strong, and at least slows down their expansion in bad fiscal times. It also liberalizes entitlements in bad economic times.

That bears centrally on the current reform question.  Our entitlements are, no surprise, on an unsustainable path. We will either reform them, in a way that reduces federal spending, or we will substantially raise taxes on the "middle class," including a large payroll tax increase and likely a european style VAT on top of growth-killing income and corporate taxes.

If one wishes for a reform on the expenditure side, the great question is whether it must be done directly or via "starving the beast" of tax revenue. For example, I advocate a VAT. A common complaint is that the VAT is not only a much more economically efficient way of raising a given revenue, it is a great way to raise much more revenue, and my critics complain it soon will do that and provoke even greater spending. The VAT shifts the top of the Laffer curve to the right, and in my critics' view, the US government will operate at the top of the long-run Laffer curve given structural limitations on its tax code.

I have held out hope that our democracy could contain itself to spend less than the top of the Laffer curve allows, so we can jettison the insane inefficiency and corruption of our tax code, and have one that is vastly more economically efficient. The opposite view really amounts to belief that democracy is fatally flawed. Moreover, I note that starve the beast tax reductions have led to massive deficit expansions, yet large debt and deficits have not yet seemed to provide much pressure against entitlement spending.

John's history is a strong push toward starve the beast, at least in the negative direction. Surpluses lead to benefit expansions, quickly.

Another theme: The accounting gimmicks such as "trust funds." Surpluses in trust funds lead to benefit expansions, even if there are huge deficits outside. And "trust fund" accounting gimmicks also go back a long way.

As we (hopefully) start to think about reform, I think the only hope is to break out of "we're spending too much there will be a debt crisis" vs. "you heartless evil person, just look at (deserving person). How can you throw her off the bus." The way to do that, I think, is to focus on the disincentives of our social programs, not on the cost or the worthiness of recipients. I find some comfort in John's history, that occasional retrenchments, including the above and the welfare reforms of the 1990s got through politically by looking at fraud (a form of disincentive) and other disincentives.

This is a history and a political history, not a reform proposal, nor an economic analysis of disincentives. Still, John's history is also full of quotes reflecting the centuries old tension in welfare programs between helping those in need and disincentives, which I'll cover in the next post. That history ought to help.

A note for graduate students: This book is very well written, and you should read it to emulate writing style as well as for the subject. No, it does not knock you over the head with beautiful sentences as John McPhee might. It is, however, beautifully structured. The whole book and each chapter starts with a complete summary of the argument, and the chapter fills it out. It could go on for thousands of pages, but manages to tell just enough of the story so you see the historical detail, but not enough so you get lost in what must been have fascinating historical detail. Yet this is not a standard quickie book aimed at a policy controversy. This is a deep piece of scholarship. Everything is footnoted -- 78 pages of footnotes and reference all together.

Hoover has just announced the 2018 Summer Boot Camp August 19-25 2018

The Hoover Institution’s Summer Policy Boot Camp (HISPBC) is an intensive, one week residential immersion program in the essentials of today’s national and international United States policy. The program is intended to instruct college students and recent graduates on the economic, political, and social aspects of United States public policy. The goal is to teach students how to think critically about public policy formulation and its results.

Using a highly interactive, tutorial-style model designed to foster fact-based critical thinking on the most important policy issues, students will have a unique chance to interact directly with the faculty of Stanford University’s Hoover Institution, comprised of world-renowned scholars in economics, government, political science, and related fields.  Each half-day will be dedicated to one topic, chosen because of its immediate relevance to today’s and tomorrow’s challenges. Participants will collaborate through class discussions, study groups, and team projects that encourage diverse perspectives. Enrollment is limited, in order to facilitate maximum interaction with the faculty and other participants.

This was a big success last year. I taught one section of the bootcamp, and I thought the students were a great cross section of really interesting smart people.

Oh, and it's free.

The public and media discussion of "net neutrality" seems to have degenerated to "we want stuff for free." In the end, it does cost something to deliver internet, and the bandwith is limited.

The (artfully named) "net neutrality" regulation was really a return to utility rate regulation, in which the regulators say who gets what, and how much they can charge. Just what a rosy success that was not, seems to have been forgotten.

In this context, it seems especially worth reporting on an event from last week. Tom Hazlett, former Chief Economist of the FCC, came to Hoover  to discuss his new book "Political Spectrum,"  which covers the history of the US government regulation of radio (TV, and cell phone) waves, largely through the same FCC that was in charge of "net neutrality." (I haven't read the book, this is a summary of the seminar discussion.)

Contrary to conventional wisdom, the market for spectrum worked well until 1927, in just the way economists might expect. Property rights to spectrum emerged, evolved, and worked well.

Radio was, at first, considered only for point to point communication. It stayed that way until 1920, when the first broadcast occurred.  Within 2 years there were 500 broadcasters.

Contrary to the common allegation of “etheric bedlam” the market was actually orderly through 1926.  Under the 1912 radio statute, the Department of Commerce enforced first-come first-serve rules, basically homesteader rights to spectrum in a geographic area and time. Those emergent property rights were registered with Department of Commerce, and easily bought and sold. If a new station encroached on your frequency/geography, you could quickly sue and stop it.

Regulation emerged in much the way a public choice economist might predict. The regulators wanted much more discretion — they wanted to control who got to broadcast and what was said. The  large commercial stations wanted to limit entry and competition. The National Association of Broadcasters quickly became a lobbying group and advocated “public interest, convenience, and necessity” to regulate. [Yes, in only 5 years an industry that nobody had ever heard of or thought of became an incumbent lobbying force for regulation to stop entry and competition.]  Herbert Hoover, (sadly) the commerce secretary at the time stopped enforcing enforcing first-come first-serve rights in 1926. Now there was indeed chaos, the “breakdown in the law.” According to Hazlett, this was a strategic breakdown to get regulation going. That regulation was formalized in the 1927 radio act. The first sentence of the act preempted private rights to spectrum.

Now, rather than property rights, spectrum was allocated by a “mother may I” system.  In 1932 FCC,  took over authority of wires to.

Regulation was quickly captured to stop competition and innovation.


Hazlett offered FM radio as the classic example. Howard Armstrong (famous inventor) in 1933 created FM radio, which as we know is technically much better than AM. He had to ask the FCC for spectrum. FCC experts said it wouldn’t work. In 1939 he finally got some spectrum  allocation for FM, and started selling FM radios. WWII stopped everything, as civilian radio production stopped. In 1945, broadcast TV lobbied the FCC for the FM spectrum, and the FCC moved FM from the 40 mhz range to 88-108 Mhz, making all existing radios obsolete. Armstrong had to start over. When finally in the 1960s FM was finally allowed, it immediately took over from AM for music; [as we know it has much wider frequency response, and “no static at all”.]

That’s a nutshell of “mother may I” regulation — it suppresses competition and deters innovative technologies, in this case for a quarter century.

Again in the 1960s, TV and cable repeated the story, regulation used to protect incumbents and stop innovation.

In likely the most famous speech by an American regulator, May 9 1961,  FCC chairman Newton N. Minow characterized TV as a “vast wasteland.”  He forced stations to show “public interest” to get a license renewal.

In the early 1960s, cable began to compete. Broadcasters naturally tried hard to stop it. From 1948-to the 1960s, cable only extended the range of broadcast TV signals. But in the 60s, cable started to offer competing broadcasts. The over the air broadcasters got Minnow to block cable, on the grounds that cable would destroy broadcasters’ profitability, and therefore their provision of public interest news and other public interest programming. This lasted until the late 1970s.

In an equally famous and vilified speech, FCC chairman Mark Fowler argued that “TV is just a toaster with pictures.” He argued for competition, free entry, entrepreneurship and letting people choose. He argued against the “public interest” standard, and for minimalist regulation.

Cable was deregulated. It immediately produced hundreds of channels, including CSPAN, and the all-news CNN. The result was, ironically much more news and public affairs, just what FCC said it was protecting, in place of networks’ 15 minute nightly news.

Hazlett covers the decades-long still-partial liberalization, and a lot of interesting detail on how spectrum auctions work (and don't work).

1st generation  wireless mobile got licenses in the 1980s, though the technology was announced in 1945. Getting this spectrum allocation was called the “30 years’ war.”

In the 1970s, the FCC decided that only a monopoly can do cell phone service, and  gave it to Bell. By the 1980s radicals said maybe there could be 2 cell phone companies. The Department of Justice had to sue the FCC to get more than one license.

Even in the first generation, there were only 2 competitors, and standards  were set by the government. By early 2000 though, the US and  many countries auctioned licenses and allowed liberal de-facto property rights. Regulators now allow mobile licensees to figure out networks, architecture (size, location, and  power of stations), and use their own applications. In 2005, the iPhone was like FM, and needed spectrum. But this time it didn’t have to ask permission. Apple negotiated with Verizon and AT&T, initially going with AT&T exclusive for the iphone. It ended up that the price was negative — carriers wanted the iPhone on their network enough to pay for it.

2- 5 G wireless and the “internet of things,” is built through private coordination. But it is fragile. The old law is in place.  Regulators have simply interpreted their mandate for “public interest,” and that liberalization and rights are working.

Most spectrum is still regulated. Of the “beach front”  under 4 Ghz ,15% (mobile) is largely unrestricted, assigned by auction. About half is allocated to government, military, and forestry, and a wide swath is still owned by broadcast TV.

Now, do you really want the FCC to decide who gets to put what on the internet, how much they get to charge, and to control its architecture?

Law and the Regulatory State is a little essay, my contribution to American Exceptionalism in a new Era, a volume of such essays by Hoover Fellows. It takes up where Rule of Law in the Regulatory State left off.

A few snippets:

To be a conservative—or, as in my case, an empirical, Pax-Americana, rule-of-law, constitutionalist, conservative libertarian—is pretty much by definition to believe that America is “exceptional”—and that it is perpetually in danger of losing that precious characteristic.  

So why is America exceptional, in the good sense? Here, I think, economics provides a crucial answer. The ideas that American exceptionalism propounds have led to the most dramatic improvement in widely shared well-being in human history.... Without this economic success, I doubt that anyone would call America exceptional. 

Despite the promises of monarchs, autocrats, dictators, commissars, central planners, socialists, industrial policy makers, progressive nudgers, and assorted dirigistes, it is liberty and rule of law that has led to this enormous progress. 

I locate the core source of America’s exceptional nature in our legal system—the nexus of constitutional government, artfully created with checks and balances, and of the rule of law that guides our affairs. And this is also where I locate the greatest danger at the moment. 

The erosion of rule of law is all around us. I see it most clearly in the explosion of the administrative, regulatory state.

This is the main theme:

the rules are so vague and complex that nobody knows what they really mean..  the “rules” really just mean discretion for the regulators to do what they want—often to coerce the behavior they want out of companies by the threat of an arbitrary adverse decision.

The basic rights that citizens are supposed to have in the face of the law are also vanishing in the regulatory state.

Retroactive decisions are common,..

I fear even more the political impact. ... The drive toward criminalizing regulatory witch hunts and going after the executives means one thing: those executives had better make sure their organizations stay in line.

The key attribute that makes America exceptional—and prosperous—is that candidates and their supporters can afford to lose elections. Grumble, sit back, regroup, and try again next time. They won’t lose their jobs or their businesses. They won’t suddenly encounter trouble getting permits and approvals. They won’t have alphabet soup agencies at their doors with investigations and fines... We are losing that attribute.

In many countries, people can’t afford to lose elections. Those in power do not give it up easily. Those out of power are reduced to violence. American exceptionalism does not mean that all the bad things that happen elsewhere in the world cannot happen here.

Always be optimistic though:

The third article in exceptionalist faith, however, is optimism: that despite the ever-gathering clouds, America will once again face the challenge and reform. There is a reason that lovers of liberty tend to be Chicago Cubs fans.

The other essays are great. Niall Ferguson basically thinks exceptionalism is over.

Source: Wall Street Journal

So, what's up with Bitcoin? Is it a "bubble?'' A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some "excess valuations" in stock markets, gold and commodities, and money itself.

Let's put the pieces together. The first equation of asset pricing is that price = expected present value of dividends. Bitcoin has no cash dividends, and never will. So right off the bat we have a problem -- and a case that suggests how other assets might have value above and beyond their cash dividends.

Well, if the price is greater than zero, either people see some "dividend," some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called "convenience yield," the latter is a "rational bubble."

"Rational bubbles" are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The "greater fool" or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let's think about "convenience yield." Why might someone be willing to hold bitcoins even though their price is above "fundamental value" -- equivalently even though their expected return over a decently long horizon is lower than that of stocks and bonds? Even though we know pretty much for sure that within our lifetimes bitcoin will become worthless? (If you're not sure on that, more later)


Well, dollar bills have the same feature. They don't pay interest, and they don't pay dividends. By holding dollar bills, you are holding an asset whose fundamental value is zero, and whose expected return is demonstrably lower than that of, say, one-year treasuries. One year Treasuries are completely risk free, and over a year will give you about 1.5% more than holding dollar bills. This is a pure arbitrage opportunity, which isn't supposed to happen in financial markets!

It's pretty clear why you still hold some dollar bills, or their equivalent in non-interest-bearing accounts. They are more convenient when you want to buy things. Dollar bills have an obvious "convenience yield" that makes up for the 1.5% loss in financial rate of return.

Also, nobody holds dollar bills for a whole year. You minimize the use of dollar bills by going to fill up at the ATM occasionally. And the higher interest rates are, the less cash you hold and the more frequently you go to the ATM. So, already we have an "overpricing" -- dollars are 1.5% higher priced than treasurys -- that is related to "short-term investors" and lots of trading -- high turnover, with more overpricing when there is more trading and higher turnover -- just like bitcoin. And 1999 tech stocks. And tulip bubbles.

Some of the convenience yield of cash is that it facilitates tax evasion, and allows for illegal voluntary transactions such as drugs and bribes. We can debate if that's good or bad. Lots of economists want to ban cash (and bitcoin) to allow the government more leverage. I'm less enthusiastic about suddenly putting out of work 11 million undocumented immigrants and about half of small businesses. The US tends to pass a lot of aspirational laws that if enforced would bring the economy to a halt. To say nothing of the civil liberties implications if the government can track every cent everyone has ever spent.

But US cash is largely stuffed in Russian mattresses. It is even less obvious that it is in our interest to enforce Russian laws on taxation or Russian control over transactions. Or Chinese, Venezuelan, Cuban, etc. control.

And more so bitcoin. This is the obvious "convenience yield" of bitcoin -- the obvious reason some people are willing to hold bitcoin for some amount of time, even though they may know it's a terrible long-term investment. It certainly facilitates ransomware. It's great for laundering money. And it's great for avoiding capital controls -- getting money out of China, say. As with dollars there is a lot of bad in that, and a lot of good as well. (See Tyler Cowen on some parallel benefits of offshore investing.)

But good or bad is beside the point here. The point here is that there is a perfectly rational demand for bitcoin as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth -- even if people holding it know that it's a terrible long-term investment.

On top of this "fundamental" demand, we can add a "speculative" demand. Suppose you know or you think you know that bitcoin will go up some more before its inevitable crash. In order to speculate on bitcoin, you have to buy some bitcoin. I don't know if you can short bitcoin, but if you wanted to you would have to borrow some bitcoin and sell it, and in the process you would have to hold some bitcoin. So, as we also see in high-priced stocks, houses and tulips, high prices come with volatile prices (so there is money to be made on speculation), and large trading volumes. Someone speculating on bitcoin over a week cares little about its fundamental value. Even if you told him or her that bitcoin would crash to zero for sure in three years, that would make essentially no dent in their trading profits, as you can make so much money in a volatile market over a week, if you get on the right side of volatility.

Now to support a high price, you need restricted supply as well as demand. There are only so many bitcoins, as there are only so many gold bars, at least for now.  But that will change. The Achilles' heel of bitcoin's long term value is that there is nothing to stop people from creating bitcoin substitutes -- there are already hundreds of other similar competitors. And there is nothing to stop people from creating private claims to bitcoin -- bitcoin futures -- to satisfy speculative demand. But all that takes time. And none of my demands were from people who want to hold bitcoin for very long.  Ice cream is also a fast-depreciating asset, but people hold it for a while. In this view, however, Bitcoin remains a terrible buy-and-hold asset, especially for an investor who plans to pay taxes.

In sum, what's going on with Bitcoin seems to me like a perfectly "normal" phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and limits on short-selling, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand -- no annual reports on how much the Russian mafia wants to move offshore next week -- that's plausible too.

This view says that price surges only happen with restricted supply, and accompany price volatility, large trading volume, and short holding periods. That's a nice testable link, which seems to hold for bitcoin. And other theories, such as madness of crowds, no not explain that correlation.

Bitcoin is not a very good money. It is a pure fiat money (no backing), whose value comes from limited supply plus these demands. As such it has the huge price fluctuations we see. It's an electronic version of gold, and the price variation should be a warning to economists who long for a return to  gold. My bet is that stable-value cryptocurrencies, offering one dollar per currency unit and low transactions costs, will prosper in the role of money. At least until there is a big inflation or sovereign debt crisis and a stable-value cryptocurrency not linked to government debt emerges.

(This view is set out in more detain in a paper I wrote about the tech stock era,  Stocks as Money in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003. Alas not available online, but the link to my last manuscript works.)

Update: Marginal Revolution also on bitcoin today.

Mind the Gap is an extraordinary blog post on land use regulations. (HT the dependably excellent Marginal Revolution.) It is great for its detail, but most of all for its fresh voice. Sure, send one of my free-market economist friends in to examine the pathologies of any city, and we start almost reflexively on land use regulations. But the author is clearly from a different background -- the sort of person who "was in Hamtramck, Michigan a couple of years ago to participate in a seminar about reactivating neighborhoods." Lessons discovered the hard way, from different backgrounds, are often the freshest.

The big point of the blog post is how land use regulations force a steppingstone pattern of urban decay. It's hopelessly expensive to convert any building "up" the economic foodchain of uses, so bit by bit buildings get used for less and less productive uses, that don't attract the attention of regulators, until they become vacant lots, or until a large commercial developer can come in, demand tax subsidies, and rebuild the whole neighborhood.

The post starts with the story of a family that

bought an old fire station a few years ago with the intention of turning it in to a Portuguese bakery and brew pub.

Alas,

Mandatory parking requirements, sidewalks, curb cuts, fire lanes, on site stormwater management, handicapped accessibility, draught tolerant native plantings… It’s a very long list that totaled $340,000 worth of work. They only paid $245,000 for the entire property. And that’s before they even started bringing the building itself up to code for their intended use. Guess what? They decided not to open the bakery or brewery. Big surprise.

(The post is full of great photographs like this one.) So instead,

the space has been pressed in to service as a printing shop for the family’s specialty advertising business. It’s a productive and profitable use of the existing space that doesn’t require structural changes or special regulatory approval. But it’s significantly lower down on the economic food chain, creates less taxable revenue, employs far fewer people, and does nothing to activate the town’s social or cultural life. And if anything were to happen to the building it wouldn’t be cost effective to rebuild so the lot would most likely remain vacant. There are plenty of empty parcels all around that attest to this reality.

The conundrum

Individually it’s impossible to argue against each of the particulars. Do you really want to deprive people in wheelchairs of the basic civil right of public accommodation? Do you really want the place to catch fire and burn? Do you want a barren landscape that’s bereft of vegetation? 

Here I think the blog missed the central problem -- understandable since it's not from an economist. "you" -- we, the town, really does want these things. These are important, and desired, public goods. The problem is, these things we want cost a lot of money. $340,000 for one firehouse. The town wants them, but is not willing to raise general taxes to pay for them.  It's sane enough to realize that it cannot make owners of existing properties fork over $340,000 per firehouse. So it passes, what is in essence, a lump-sum tax on people who want to start new businesses, or use the property up the economic foodchain. Alas, the people second-most-unlikely to be willing or able to pay such taxes are small-scale entrepreneurs trying to start a marginally better business in a run down neighborhood.  So nothing happens until either the town reverts to wasteland, or until nearby prospects brighten enough that a large commercial developer can move it back to the top of the food chain, and also extract enough tax breaks so that in essence the city does pay for the public goods from general taxes in the first place.

The post though, is about this big lesson in urban decay:

There is zero chance that any of these laws and procedures will be changed in my lifetime. However, it’s highly likely that before I die this gas station will close and the property will work its way down to a series of lesser uses until it remains vacant....And before I shuffle off this mortal coil the cost of maintaining the road and associated sewer and water infrastructure will outstrip this town’s tax revenue. 

(The post also emphasizes the dehumanizing aspect of parking and street regulations.)

Another example, on trying to convert an old bank to new uses,

 the fire marshal happened to drive by and noticed there were people – a few dozen actual humans – occupying a commercial building in broad daylight. In a town that has seen decades of depopulation and disinvestment this was an odd sight. And he was worried. Do people have permission for this kind of activity? Had there been an inspection? Was a permit issued? Is everything insured? ...

There was already a kitchen in the back of the building from when the place had been a Chinese restaurant. But the current rules required a long list of upgrades including a $20,000 fire suppressing hood for the stove and new ADA compliant bathrooms. It could all be done, but at a price point that would grossly exceed both the purchase price of the building and any conceivable cash flow the business might generate.

One work-around was to have a certified and inspected food truck park in the back alley and deliver food into the building for temporary events. ADA portable toilets could be rented as needed. The building – now called Bank Suey – has continued along these lines as a rental hall for pop up events..

Clearly a move down the economic food chain. Cell phone antennas on the roof of a neighboring empty building are the next example.


Our author has learned an important lesson.

On a walking tour of town officials and development consultants pointed to empty buildings and described all the things that could be done to bring them back to productive activity: open up the blank walls and re-install windows, incubate all kinds of new businesses, paint, outdoor seating… I rolled my eyes. None of those things make any economic sense given the regulatory hurdles involved and the likely negative return on the up front investment

The pattern instead, and the bottom line:

anonymous blank inscrutable structures ... could quietly contain storage facilities or a non retail live/work space under-the-radar without attracting the attention of officialdom. If the inhabitants were really discrete they might be able to carry on unmolested for a number of years. 

Meanwhile the usual big money developers might buy enough of the neighboring buildings and vacant land – with the accompanying subsidies and tax breaks – to rapidly transform Main Street at a much higher economic level. 

There’s no in-between. You either get permanent stagnation or massive redevelopment. Baby steps are essentially illegal.  

The WSJ has two good and related opeds on energy and transport subsidies recently, Randall O'Toole on Last Stop on the Light-Rail Gravy Train and Lee Ohanian and  Ted Temzelides write on energy and transport subsidies

O'Toole:

Last month, Nashville Mayor Megan Berry announced a $5.2 billion proposal that involves building 26 miles of light rail and digging an expensive tunnel under the city’s downtown. Voters will be asked in May to approve a half-cent sales tax increase plus additions to hotel, car rental and business excise taxes to pay for the project.

Just in time for self-driving Ubers to arrive.

I love trains. But we have to admit practicalities. One transportation economist summed all there is to know about transit with "Bus Good. Train Bad." (With a few exceptions, such as Manhattan.)  And light rail, worse. Trains are expensive, and once built, immobile. If people want to go somewhere else, tough. Rolling stock lasts around 50 years, meaning they bake in technical obsolescence. Trains carry far fewer people per lane-mile than busses. And a fleet of self-driving Ubers linked by computer will be able to use bus lanes.

Actually, even buses are more and more questionable. As I wait for the interminable lights on El Camino to cross to Stanford (on bicycle), I have taken to counting passengers on the well-subsidized bus line. The modal number is zero.

As Randy has pointed out elsewhere, the main beneficiaries of light rail are suburban largely white commuters with a nostalgia thing for trains. The main people paying for it are inner city minorities who don't get bus service anymore.

To pay for new light-rail lines that opened in 2012 and 2016, Los Angeles cut bus service. The city lost nearly four bus riders for every additional rail rider.

Congestion got you down? Real time tolling, adjusted minute by minute, will either cure traffic congestion forever, or will bail out indebted local governments with massive revenues, or both. Or, let people live somewhere near where they work!

Lee and Ted consider the transition from horse to auto and truck,

‘In 50 years, every street in London will be buried under 9 feet of manure.” With this 1894 prediction, the London Times warned that the era’s primary source of transportation energy—the horse—would soon create an environmental crisis. ...

The enormous demand for a cleaner and more efficient source of energy led to remarkable innovations in the internal combustion engine. By 1920 horses in cities had been almost entirely replaced by affordable autos and trucks...

And to be honest, horse manure replaced by auto exhaust -- but as bad as auto exhaust is, it's a lot better than horse manure.

Suppose governments in the 1890s, desperate to replace the horse, had jumped on the first available alternative, the steam engine. Heavy subsidies would have produced more steam engines and more research on steam technology. This would only have waylaid the development of the far superior internal combustion engine. 

Source: Obtainium works.

(Actually, the government did subsidize railroads a good deal, and perhaps by doing so did stall the development of the truck.)

More than horse manure, I love the image of an alternate reality steampunk America...At left a cool  steampunk RV. (Image source)

Which brings us back, I'm afraid to the main force behind rail subsidies, which Randall has pointed out before: Nostalgia. Nostalgia for what seems like a simpler age. I understand that too. I love trains. But that doesn't make them practical, especially at billions of dollars per mile.

If we're doing nostalgia, how about doing it full time -- high speed stagecoach lines? Bring back the horse! It's all renewable!'

The real questions the Fed should ask itself.  This is a cleaned up and edited version of a previous blog post, commenting among other things on Janet Yellen's Jackson Hole speech in favor of most of Dodd Frank, that appeared in the Chicago Booth Review. When you think of the Fed, think more of the giant regulator than about where interest rates go.

Tyler Cowen wrote an extended blog post on bank leverage, regulation and economic growth on Marginal Revolution. Tyler thinks the "liquidity transformation" of banks is essential, and that we will not be able to avoid a highly levered banking system, despite the regulatory bloat this requires, and the occasional financial crisis. As blog readers may know, I disagree.

A few choice quotes from Tyler, though I encourage you to read his entire argument:

I think of the liquidity transformation of banks in terms of...Transforming otherwise somewhat illiquid activities into liquid deposits. That boosts risk-taking capacities, boosts aggregate investment, and makes depositors more liquid in real terms.  

Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. 

...many economies are stuck with the levels of leverage they have, for better or worse. 

I fear ... that we will have to rely on the LOLR function more and more often. 

I don’t find the idea of 40% capital requirements, combined with an absolute minimum of regulation, absurd on the face of it. But I don’t see how we can get there, even for the future generations.

Depressing words for a libertarian, usually optimistic about markets.

This is a good context to briefly summarize why "narrow", or (my preferred) equity-financed banking is in fact reasonable, and could happen relatively quickly.

Tyler's main concern is that people need a lot of "liquidity" -- think money-like bank accounts -- and that unless banks can issue a lot of deposits, backed by mortgages and similar assets, bad things will happen -- people won't have the "liquidity" they need, and businesses can't get the investment they need.

Here are a few capsule counter arguments.  In particular, they are reasons why the economy of, say 1935 or even 1965 might have required highly levered banks, but we do not.

1) We're awash in government debt.



We've got about $20 trillion of government debt. That could back about $20 trillion of risk free assets. (It would be better still if the Treasury would issue fixed-value floating-rate debt, needing no intermediation at all.) Add agency debt -- backed by mortgage backed securities that are already guaranteed by the Treasury -- and you have another $8 trillion. Checking accounts are about $1.5 trillion and total bank liabilities about $9 trillion.

In the past, we may have needed to create money-like deposits by backing them with bank assets. A happy side to our debt expansion is that government debt -- the present value of the governments' taxing authority -- provides ample assets to back all the money-like deposits you want.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid 

In the past, the only way that a security could be "liquid" is if it promised a fixed payment. You couldn't walk in to a drugstore in 1935, or 1965, and trade an S&P500 index share for a candy bar.  Now you can. (And as soon as it is cleared by blockchain, it will be even faster and cheaper than credit cards.) There is no reason your debit card cannot be linked to an asset whose value floats over time.

This is the key distinction. The problem with short term debt is that it is prone to runs. Financial crises are runs, period.  Short term debt is prone to runs because it promises a fixed amount ($1), any time, first come first serve, and if the institution does not honor the claim it is bankrupt.

Seriously. Imagine that your debit card was linked to an ETF that held long-only, full allocations (not risky tranches) of high grade mortgage backed securities. Its value would float, but not a lot. Bank assets are, curiously immensely safe. So it might go up or down 2% a year. In return you get a higher interest rate than on pure short-term government debt (of which there is $28 trillion under my scheme).  You would hardly notice. Yet the financial system is now immune from runs!

3) Leverage of the banking system need not be leverage in the banking system. 

Suppose even this isn't enough and we still need more risk free assets. OK, let's lever up bank assets. But why should that leverage be in the bank. Let the banks issue 100% equity. Then, let most of that equity be held by a mutual fund, ETF, or bank holding company, and let those issue deposits, long term debt, and a small amount of additional equity. Now I have "transformed" risky assets into riskfree debt via leverage. But the leverage is outside the bank. If the bank loses money, the mutual fund, ETF, or holding company fails... in about 5 minutes. The creditors get traded equity of the bank, which is still at 90% of its initial value. There is no reason bank creditors should dismember a bank, go after complex and illiquid bank assets, stop operation of the bank. If bank assets must be leveraged, put that leverage outside the bank.

And, if you need even more leverage, well, these leveraged ETF can hold other assets too. There is no reason not to leverage up stock, corporate bonds, REITS, mortgage backed securities or other assets if we desperately need to provide a riskfree tranche. We don't see this. Why not? Maybe "riskfree" assets aren't so important after all!

Tyler sort of acknowledges this, but with fear rather than excitement:

But what if a demand deposit is no longer so well-defined? What about money market funds? Repurchase agreements? Derivatives and other synthetic positions? Guaranteeing demand deposits is a weaker and weaker protection for the aggregate, as indeed we learned in 2008. The Ricardo Hausmann position is to extend the governmental guarantees to as many areas as possible, but that makes me deeply nervous. Not only is this fiscally dangerous, I also think it would lead to stifling regulation being applied too broadly. 

A lot of commercial bank leverage can be replaced by leverage from other sources, many less regulated or less “establishment.” Overall, on current and recent margins I prefer to keep leverage in the commercial banking sector, compared to the relevant alternatives....One big problem with attempts to radically restrict bank leverage is that they simply shift leverage into other parts of the economy, possibly in more dangerous forms...

Absolutely. In my view nobody should issue large quantities of run-prone assets -- fixed value, immediate demandability, first come first serve -- unless backed by government debt. However, we should cherish the rise of fintech that allows us to have liquidity without run-prone assets. And don't fear even leverage outside commercial banks without thinking about it. My ETF, whose assets are common stock, and liabilities are say 40% "deposits", 40% long-term debt, and 20% equity, really could be recapitalized in 5 minutes, without any of the adverse consequences of dragging a bank through bankruptcy court.

4) Inadequate funds for investment I'm not quite sure where Tyler gets the view that without lots of unbacked deposits, funds for investment will be scarce -- just how leverage

boosts risk-taking capacities, boosts aggregate investment,...

Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession. 

The equity of 100% equity financed banks would be incredibly safe. 1/10 the volatility of current banks. It would be an attractive asset. The private sector really does not have to hold any more risk or provide any more money to an equity financed banking system. We just slice the pizza differently. If issuing equity is hard, banks can just retain profits for a decade or so.

Or, better, our regulators could leave the banks alone and allow on on-ramp. Start a new "bank" with 50% or more equity? Sure, you're exempt from all regulation.

And, in case you forgot, we live in the era of minuscule interest rates -- negative in parts of the world; and sky high equity valuations. All the macroeconomic prognosticators are still bemoaning a "savings glut." A scarcity of investment capital, needing some sort of fine pizza slicing to make sure just the right person gets the mushroom and the right person gets the pepperoni does not seem the key to growth right now.

Update: Anonymous below asks a good question: "What about payrolls, debiting and crediting exports and foreign transactions, escrows."  And I could add, accounts receivable, trade credit and so forth.

Answer: We need to eliminate large-scale financing by run-prone securities. Not all debt is run prone. It needs to be very short term, demandable, failure to pay instantly leads to bankruptcy, and first come first serve. And it has to be enough of the institution's overall financing that a run can cause failure. An IOU for a bar bill -- pay for my beer, I'll catch up with you next week -- is a fixed-value security, yes. But it is not run prone. You can't demand payment instantly, bankrupt me if I don't pay, I have the right to postpone payment,  it's not first come first serve, and such debts are a tiny fraction of my net worth.

Update: A correspondent writes

[Equity financed banking] Already exists! Albeit not at scale yet. It’s called asset management. See, for example, Alcentra, a UK-based company that lends directly to mid-sized European companies. They are largely “equity financed,” meaning that they sell shares in their funds, mostly to institutional investors. They also offer separate accounts, which you can also think of as “equity financing.” They are not a bank, but an asset manager, taking advantage of reduced lending since the crisis by banks to mid-sized and low credit firms in Europe. They have about 30 billion in AUM. This is a “disintermediation” story no one is talking about, and direct lending by asset managers is on the rise more broadly as well.