Economist Channel

More Bank Capital Could Kill the Economy write Tim Congdon and the usually sensible Steve Hanke in today's Wall Street Journal.

I was expecting a quantitative disagreement on plausible channels -- some explicit violation of the Modigliani Miller theorem, some reason that splitting the pizza into 8 slices rather than 4 will help your diet, some argument that relationship lending is inherently tied to short-term funding, and so forth. Instead, we got treated to one of the most illogical conclusions I've seen on the WSJ pages for a long time.


This is a really important argument to revisit, at a really sensitive time.  Right now, the Administration wants to rethink Dodd-Frank. Great. But they could go in two ways: 2) increase capital a lot, and get rid of all the intrusive and stultifying risk regulation and anti-competitive regulation; 2) reduce capital requirements a lot, so the big banks go on an orgy of government-guaranteed borrowing and risky investment. From my last post you can see it going either way. Anti-capital fallacies just pour slops into the second trough.

Their argument:

Here’s what really went wrong in the fall of 2008... Regulators were in such a panic that they hastily increased banks’ capital requirements from 4% to 7%, without thinking through the long-term ramifications.

There are two ways for banks to raise their capital-to-asset ratios: by increasing capital or decreasing assets. Which is most likely during a crisis? Issuing new equity or bonds would be difficult under crisis conditions, so banks will instead shed risky assets. In late 2008 and early 2009 that meant a drop in lending to the private sector and a credit squeeze. As businesses repaid loans, new ones were not issued in their place and the quantity of money in the economy fell. That hit demand, spending and jobs, just as it had in the Great Depression.

What was the fallout? In the five years preceding October 2008, bank lending to the private sector had soared by more than 75%, according to Fed data, from $4.2 trillion to $7.4 trillion. In the five years after, bank lending stagnated, increasing by less than 10%.   

The stock of loans actually went down during the first two years of this period, the only time such a thing has happened on a significant scale since the 1930s. The reversal was most extreme for industrial and commercial loans, which plunged from $1.6 trillion at the end of October 2008 to $1.2 trillion two years later. 

...The blame for this credit crunch falls on the Fed, acting in concert with the Bank for International Settlement 

Let's leave aside quibbling about the facts -- just what capital requirement they are talking about, when it it, and so forth. Leave aside the great argument whether any of this even happened in the crisis -- whether regulatory capital constraints were binding (the banks said no), and whether banks as a whole shed risky assets. Leave aside the "the quantity of money in the economy fell," and ignore the graph below:




Consider the logic of the argument. A rise in capital requirements in Fall 2008, singlehandedly caused a "credit crunch," and lending to "plunge," and bank lending to "stagnate" for five years. Among other influences not held constant here, let us not forget the TARP, which, like it not (I don't) gave the banks a massive shot of... capital.

That brings us to Mr. Kashkari’s proposal to further double capital requirements. What might happen if the Trump administration enacted his plan? Bank stocks would take another dive. They would find it impossible to raise new capital through equity or bond issues, so they would be forced to shed assets. As in 2009 and 2010, banks would refuse applications for new loans. They might go so far as to wriggle out of contracts for existing loans and ask for early repayment.

(Kashkari and a lot of others I might note -- especially the courageous Admati and Hellwig, and on the political side Jeb Hensarling. )
Here you see the deep illogic of the oped: It concludes, from the assertion that banks in the middle of a once per half century financial crisis, cannot raise capital in a week by means other than selling assets (even if that assertion is true), that banks cannot over five years or more, of normal and healthy financial markets, raise adequate capital to bear the brunt of the next crisis without cutting lending.

Banks have many ways to raise capital in functioning markets, and even in relatively dysfunctional markets. Even in 2007, if memory serves me right (there was a Bloomberg.com article on this I can't find right now, I welcome a source), banks raised something like a trillion dollars of new equity, in order to cover losses in their asset positions. When buyers come and take over a bank, that is an equity injection. Lehman itself was poised to be bought in this way, until UK regulators nixed the deal. Banks can reduce dividend payments, which increases the total value of equity, or big payouts to senior employees. If banks aren't lending, in a functional regulatory market (not ours) new banks can IPO and take over their business. In two weeks, in the middle of a crisis? Maybe not. In five years? That does not follow.

Yes, in a city-wide conflagration, "Everybody run down to Home Depot, buy and install sprinklers,  and grab a carful of fire extinguishers" is not going to work. It does not follow that in the five following years a city code that requires sprinkler retrofits and fire extinguishers cannot stop the next fire from happening.

And really -- after all the stress tests, after all the slow, modulated, carefully pre announced capital raises by the Fed and others, do you really think banks would be faced with an overnight, increase capital by tomorrow morning or else? I know regulators can be a bit thick at times, but not that much!

Banks have been required to hold more capital against their risky assets, in the belief that this would make them—and the economy—safer. 

Yes, dear sirs, and that is an entirely correct belief!  Deeply, Congdon and Hanke miss the point of capital: it offers superior returns on average, but takes the losses in a crisis without needing regulators to spot the crisis, prop up markets, inject capital, lend of last resort, bailout and so forth. It's not just there to gum up the works! This is entirely missing in the article. Not enough capital did indeed cause the crisis. If banks had 20 percent capital going in, there would have been no crisis, and no bailouts, because no bank would have gone under.

Anytime a commentator writes "hold" capital you know poor logic is coming. Capital is a source of funds, not a use of funds. Capital is not reserves.

See below for two particularly important health research funding competitions currently open.

Health Research Board: Applied Partnership Awards

These support collaborative research projects between academic researchers and knowledge users, focusing on themes which are determined by the documented needs to the Irish health and social care system. Findings should have a direct impact on the decision making of the knowledge user’s organisation. Applicant teams must nominate a lead applicant for research and a lead applicant for knowledge. Lead applicant researchers must hold a post at an HRB recognised host institution in the Republic of Ireland. Co-applicants may be from outside of the Republic of Ireland. Funding is worth up to €200,000 for projects with a duration between one and two years. A minimum co-funding of 20 per cent is required. These awards will be issued under a rolling call. There will be two distinct cycles for peer-review (as below). This is to allow researchers and partner organisations to develop timely collaborations, yet have the flexibility to submit to either the first or the second peer review cycle. Peer review cycle 1 – May – August 2017. Peer review cycle 2 – October – December 2017. Full details.


Health Research Board - SPHeRE PhD programme

This aims to cultivate researchers through a four year full-time structured PhD programme. The programme is a joint initiative of the Royal College of Surgeons in Ireland, Trinity College Dublin and University College Cork, with funded scholars having the option to also register at University College Dublin, National University Ireland Galway, NUI Maynooth, the University of Limerick or Dublin City University. Individuals with an interest in carrying out research on population health or health services in the Irish context and from a wide range of academic and clinical disc iplines, including public health, health psychology, health economics, health policy, general practice, biostatistics, health geography and social science, may apply. Six full-time PhD positions are funded. The programme includes a professional skills training allowance, travel funds to national training days and international conferences, and an annual stipend of €18,000 as well as a laptop computer and PhD fees. Applications due by 12 noon, 24 March 2017. Full details.

What should the Federal Reserve do, to control inflation, given that


and that real interest rates vary over time in ways that the Fed cannot directly observe? In this post I  explore an idea I've been tossing around for a while: target the spread between nominal and indexed bonds, leaving the level of interest rates to float freely in response to market forces. (It follows Long Run Fed Targets and Michelson Morley and Occam.)

Indexed bonds like TIPS (Treasury Inflation Protected Securities) pay an interest rate adjusted for inflation. In simple terms, if a one-year indexed bond offers 1%, you actually get 1% + the rate of CPI inflation at the end of the year. So, with some qualifications (below), markets settle down to



is stable or unstable. The standard, old-Keynesian, way of thinking about it is that it is unstable. If the Fed targets the difference between nominal rate and indexed rate, the slightest puff of wind will set expected inflation spiraling away. This view would allow my first idea -- you can use this as a target, so move nominal rates aggressively to control the spread -- but not my second -- that fixing the spread expected inflation would follow.

The same question holds of standard monetary policy.  If the Fed raises the nominal interest rate and keeps it there, once real = indexed rates settle down (monetary policy does not affect real rates in the long run), does expected inflation settles down or explode? The standard view is, it explodes -- the Fed must actively move nominal interest rates to keep inflation from spiraling out of control.  Like so:

Workshop on Valuation and Well-Being 

On March 10th, we will host a workshop on valuation and well-being in Stirling University. Those with an interest in the area are welcome to attend. There is no registration fee but places are limited by space and we would ask people to register in advance at the following link. The preliminary programme is below and will be updated shortly.

Scope of Workshop 

The key aim of the workshop is to advance understanding of the comparison between different methods of revealing preferences and valuations for public and private goods. One key aspect of this is to understand how well-being and stated preferences measures compare and contrast. While there has been some literature on this, there is still a lot needed to be learned about this comparison. Furthermore, we would like to understand what new methods such as the day reconstruction method contribute to understanding about revealed preference.

- Comparing well-being and stated preference measures to value cultural and heritage goods
- Using day reconstruction methods to develop new measures of well-being and revealed preference
- The potential for validated mental health measures to be used in valuing public goods
- Examining psychological features of stated preference elicitation
- Comparing revealed and stated preference measures

Programme:

9am to 915am: Opening and Introduction: Liam Delaney (University College Dublin).

9.15 to 10am: Nick Hanley (St Andrews): “Emotions, personality and stated choices for environmental public goods”, (with Christopher and Mikolaj Czajkowski.)

10am to 1045am: Mirko Moro (Stirling): "Valuing the Environment using Well-Being Data".

Coffee 

11am to 11.45: David Comerford (Stirling): "Inferring Preferences from Choice Data: The Role of Act Utility". (with Leo Lades).

11.45 to 1230: Susana Mourato (LSE): "Well-Being and Stated Preference Approaches for Valuing Cultural and Heritage Goods".

1230 to 130: Lunch 

1.30 to 2.15: Leo Lades (Stirling): "Assessing subjective well-being when preferences are dynamically inconsistent" (with Liam Delaney).

2.15 to 3pm: Verity Watson (Aberdeen): "Using social psychology to improve stated preference responses: Evidence from the lab".

3pm to 345pm: Professor Danny Campbell (Stirling); "Response latency in stated preference surveys: does it matter?".

Conclusion and Keynote: Glenn Harrison (George State University).

Russ Roberts has an excellent essay, What do economists know? on economic humility. (HT Marginal Revolution)

A journalist once asked me how many jobs NAFTA had created or destroyed. I told him I had no reliable idea. ... 

The journalist got annoyed. “You’re a professional economist. You’re ducking my question.” I disgreed. I am answering your question, I told him. You just don’t like the answer. 

A lot of professional economists have a different attitude. They will tell you how many jobs will be lost because of an increase in the minimum wage or that an increase in the minimum wage will create jobs. They will tell you how many jobs have been lost because of increased trade with China and the amount that wages fell for workers with a particular level of education because of that trade. They will tell you that inequality lowers health or that trade with China reduces the marriage rate or encourages suicide among manufacturing workers. They will tell you whether smaller classrooms improve test scores and by how much. And they will tell you things that are much more complex — what caused the financial crisis and why its aftermath led to a lower level of employment and by how much.

And Russ continues, with great clarity, to explain just how uncertain all those estimates are.

So what do economists know? As Russ points out, much of these kind of estimates are not really produced by economics

...most of the people I am talking about are not economists. They are really applied statisticians. Economics is primarily a way of organizing one’s thinking in considering incentives and costs and the interactions between individuals that we call a market but is really emergent behavior with feedback loops.

Economists generally believe that incentives are very powerful

I'd rather he had said "Economists generally understand.." as "believe" is not a good word for any scientific enterprise. Much of the world makes sense if you recognize the power of incentives.

Yes. In just about every policy question an economist sees an incentive. Where most of our political analysis sees an income transfer. Raise gas taxes? An economist sees an incentive to drive less, move closer to work, carpool, ride a bike, buy a more efficient car. Most of our political system sees only a transfer of income, with current habits unchanged.

But I want to go further. Budget constraints and accounting identities. I think good economists quickly follow the money one more step than most analysts. If you subsidize x, then you must take money away from y. If foreigners are not able to sell things to us, then they cannot get dollars to buy things from us, or to buy assets, or to invest in the US. There is no such thing as "real" vs. "paper" investment -- each person making a "paper" investment is buying someone else's liability, which funds a "real" investment. You can't make American's wages go up, say by banning nurses from the Philippines, and also health care costs go down. We can't all buy or sell stocks -- for every buyer there must be a seller.

Unintended consequences. Our field is, perhaps, best described as a collection of funny stories about unintended consequences. (I became an economist one day very young, reading a newspaper story about a program to get rid of poisonous snakes. The government had offered a bounty on each dead snake. Guess what happened. Hint: It's easy to raise snakes.)  Unintended consequences usually come from forgetting about incentives and budget constraints. My daughter, age about 8, looked up from reading the paper one day and asked, "Dad, if the government makes everyone buy fuel efficient cars, won't they just move further from work and use the same amount of gas as before?"

Supply response, (or demand), and competition. In thinking about banking regulation, a good economist focuses on incentives for new banks to come in, rather than just how to manage the existing ones. In thinking about health care, we are all talking about how to pay for it, not about how to get new competitors to come in and offer better services. In thinking about labor regulation, we forget that the worker's ability to quit and easily get a new job, from a new hungry business trying to unseat the old one, is his or her best defense against a shoddy employer. If a drug company grabs the only FDA approval for a generic and hikes the price up insanely, the answer is competition, let others sell the drug, not price controls.

As you see, I think we're pretty good at identifying causal channels that most analysts ignore, even if we are not always great at quantifying their relative significance. But "not zero" is usually an eye opener in public policy.

The fallacy of composition ought to be right up there with correlation is not causation. Roosevelt tried to raise inflation by raising prices. Alas, you can only raise relative prices that way.  Individually, it seems we can get ahead by getting a better bargain, but my gain must be your loss and the economy does not gain overall. What's good for a business, or a bank, is not necessarily good for an economy or a banking system. A local stimulus can work by transferring resources from somewhere else. That does not mean the overall economy benefits from stimulus. Negotiating better can help one, but only at the expense of another. We can't all negotiate better.

In sum, I think economics provides an excellent set of bullshit detectors. This is my stock answer about my own professional expertise. I may not know what makes the economy grow, or how monetary policy works. But I now with great detail exactly why the ten stories in front of us are all wrong, and typically logically incoherent. That is useful knowledge.

Russ has a lovely closing paragraph, which you might miss:

But an economist when considering a policy of banning autonomous vehicles can think of a lot of other impacts besides the jobs saved and the continuing deaths from human driven cars if such a ban is put in place. One of the things we would think about is how such a ban will effect the incentives to discover future innovation that might also people out of work. We would think about how putting more power in Washington would encourage lobbying for protection. We would think about the children and grandchildren of today’s workers and how restricting technology and changing incentives would affect things. These ideas are not rocket science. But they come easily to economists and not so easily to non-economists. Thinking like an economist is very useful.

So let's call it Hayekian humility. This is the hardest one for so many economists to admit, as we all like to play central planner.

Economics and economic history also teach us humility: No economist in 1900 could have figured out what farmers, horse-shoers, ice deliverers, street-sweepers, and so forth would do when those jobs disappeared. The people involved did. Knowledge of our own ignorance is useful. Contemplating the railroad in 1830, no economist could have anticipated the whole new industries and patterns of economic activity that it would bring -- that cows would be shipped from Kansas to Chicago, and give rise to its fabled meat-packing industry. So, in a dynamic economy, all the horse-drivers, stagecoach manufacturers, canal boat drivers, canal diggers, and so forth put out of work by the railroad, and their children, were not, in the end, immiserized.

So, economics should be much better at being the ark for simple lessons of economic history and experience. Alas our current professional training makes us pretty terrible at this.

PhD training in economics focuses on theory and statistical technique, and prepares you well to do academic research. There are occasionally requirements for economic history, but these are usually economic analyses of particular episodes, i.e. training to do research as an economic historian. The sort of simple facts that Russ mentions just aren't much covered.

This isn't necessarily such a terrible thing. Physics training also doesn't cover its intellectual history that much, except for the lovely practice of repeating classic experiments. But current physics theory encodes everything you need to know about the messy experience that distills that theory. So too, perhaps, one may feel that current economic theory encodes everything you need to know about the experiences that produce such theory.

Obviously, this is a doubtful proposition, but to some extent it's true. A supply-demand curve with a price control, showing how price controls, rent controls, and minimum wages produce shortages, really does encode centuries of hard-won experience. However, social science knowledge is obviously less durable than Physics, and we see how quickly economists, armed with the theory but not the experience, can come to doubt their own knowledge. Economic models are not literal descriptions of the truth, but rather quantiative parables.

Also, many of the "facts" aren't quite facts, and really are always up for review. If we start teaching lessons of history, for example, the old chestnut that stimulus is proved by the rise in output from WWII spending -- never mind the failure of output to collapse after WWII ended, the end of Roosevelt's war on capital, the failure of hundreds of other stimulus programs or the minor fact of a war -- or how the New Deal saved us in the Great Depression, will get passed on along with valuable nuggets such as dreary repetition of experience on the effects of rent controls. Many historical issues are no less settled than the current issues that Russ talks about!

Finally, PhD training really is vocational training to do research, not to advise public policy. The market test is pretty clear -- to do research, you don't need a broad based understanding of economic history. When a research project needs a particular history, it's easy enough to learn that.

So, don't sign me up quite yet as one of those ready-for-retirement economists who bemoan too much math and not enough experience in graduate school. Actually we need more math, as the kinds of stories people talk about especially in finance are well beyond our capacity to model.

But the lack of an ark of experience, especially on microeconomic issues where they are clearer, is noticeable.

See below for the main info on our new MSc in Behavioural Economics. I direct the programme and there will be a combination of 4 new modules specifically designed for the behavioral programme and core economics modules and electives. As said below, the level of this course will require that applicants have relevant undergraduate degrees, ideally in Economics but potentially another degree with an equivalent quantitative component. The part-time option is do this over 2 years, with the dissertation at the end of the second year. This may suit people living in Ireland who have employer support to take this training. As Director, I am happy to speak to people thinking about this option and there will be scope, for example, to conduct a dissertation in an area with direct relevance to your role. MSc students will also be heavily integrated with our research group and encouraged to attend seminars, journal clubs, network events, and related activity.

MSc Behavioural Economics

Graduate Taught (level 9 nfq, credits 90)

UCD School of Economics is Ireland’s leading economics department. Our staff are experts with international reputations in a wide range of topics such as macroeconomics, econometrics, applied microeconomics, behavioural economics, health economics, international trade and economic history. School members play a significant role in debating economic policy issues and in contributing to the formulation of economic policy.  This is the only MSc in this area in Ireland and it is one of the few worldwide with a strong policy and regulatory focus.

The MSc in Behavioural Economics  is an exciting new course devoted to providing an in-depth training in the area of behavioural economics. Students will take a range of rigorous economic modules but will specialise in understanding a range of new models that incorporate the latest evidence on human decision making. As well as being trained in the core concepts and theories of behavioural economics, students will also learn about the range of empirical methods used to test ideas in this area in lab and field settings. The MSc will also cover the ethical, legal, and regulatory context for the ideas of behavioural economics. Thus, the students will be equipped to apply these ideas in a wide range of academic, business, and policy settings.

This programme features small group teaching from leading economists and a supportive environment.  Masters students are an integral part of our School community, attending research seminars and receiving a wide range of supports to help them prepare for their research thesis.

Course content & structure

This programme comprises 90 Credits of which 70 are taught and 20 are taken by dissertation.

In your first term, you will undertake a two-week preliminary course in mathematics and statistics.  You will also take the following modules:

•    Microeconomics
•    Econometrics
•    Behavioural Economics
•    Topics in Psychological Science
•    Research Skills

In your second term, you will take the following two core modules.

•    Behavioural Economics: Policy Applications
•    Experiments in Economics

You will also take two other modules. The following is an indicative list of modules that may be available:
•    Advanced Microeconomics
•    Advanced Econometrics
•    Health and Welfare Economics
•    Economics of Competition Policy
•    Energy Economics and Policy

In summer term, you will do a supervised research thesis on a topic related to behavioural economics.

What should the Fed's long-run interest rate target be? The traditional view is that the glide path should aim at 4% -- 2% real plus 2% inflation.

3%?

One big question being debated right now is whether the "natural'' real rate of interest -- r* or "r-star" in econspeak -- has declined below 2%.

Over the long run, the Fed cannot control the real rate of interest -- that comes from how much people want to save and what opportunities there are for investment, i.e. the marginal product of capital. So, if the real rate of interest is now permanently lower, say 1%, then one might argue that the glide path should aim for 3% long-run interest rate -- 1% real plus 2% inflation target -- not 4%.

Janet Yellen recently came to Stanford and gave a very interesting speech that talked in part about a lower r-star, and seemed to be heading to something like this view. See the picture:

Source: Federal Reserve.

(She also talked a lot about Taylor Rules, seeming to move much closer to John Taylor's view of how to implement monetary policy. See interesting coverage on John Taylor's blog. On r*, see Measuring the Natural Rate of Interest Redux by Thomas Laubach and John C. Williams for a central paper on r*. Henrike Michaelis and Volker Wieland have an interesting post on r* and Taylor rules, also commenting on Ms. Yellen's speech.)

Of course, cynics will say that it's just the latest excuse not to raise rates. But these are serious arguments which should be considered on their merits.

0%?

Should the glidepath head to 3% interest rates? Maybe not. How about zero?


Long ago, Milton Friedman explained the "optimal quantity of money,'' which is really the optimal interest rate. It is zero. Peramazero in St. Louis Fed President Jim Bullard's colorful terminology. At interest rates above zero, people hold less cash, and spend time and effort collecting bills early, paying them late, and so on. This is all a waste of time. Also, taxes on rate of return are a bad idea. With all rates of return that much lower, the tax distortion is that much lower. With 0% interest rates, and correspondingly lower inflation, infaltion-induced capital gains taxes vanish.

So maybe the glidepath should be to 0% interest rate, not 3%.  If the natural real rate is 1%, then inflation should be -1%.

In this line of thinking, the long-run interest rate is what counts directly. It is not a sum of a natural rate and an inflation target. Variation in the natural rate takes care of itself in variation in inflation.

4% ?

Why not? The primary reason often given is that interest rates at zero cannot go substantially below zero, at least without banning cash and many other gyrations of our monetary and financial system. So, if the interest rate is near zero, the Fed does not have "headroom" to stimulate the economy in a recession. I don't necessarily agree that this is so important, but let's go with it for a moment.

Additionally, conventional Keynesian policy analysts worry about a "deflation spiral," if the Fed can't lower rates. I'm not convinced this is a problem either, as recent experience and new Keynesian models don't spiral, (recent paper here), but again we're here today to flesh out the arguments not to adjudicate them.

(A correspondent points out Sticky Leverage by João Gomes, Urban Jermann and Lukas Schmid, and Optimal long-run inflation with occasionally binding financial constraints by Salem Abo-Zaid as two papers pointing to desirable positive long-term inflation and thus long-term nominal rates to keep away from the zero bound. Both have financing constraints as well.)

Both arguments for "headroom" above zero however seem to imply a direct nominal interest rate target, not inflation plus real rate. If the Fed needs four percentage points of headroom (2% real + 2% inflation) then it needs four percentage points of headroom (1% real + 3% inflation), no?

So, from the optimal quantity vs. zero bound-headroom argument it does not follow obviously that the interest rate target should move up and down with the ``natural rate.''

Permatwo? 

The question is, why is there a direct role for the inflation target? Why is that 2%, and then we add r* the long run real rate, to deduce the nominal rate glide point?

I think the answer is this: prices and wages are felt to be sticky, especially downward. That's the second argument against the Friedman rule: its steady deflation is said to require people to change prices and wages downward. That is said to cause disruption.

OK (maybe), no Friedman-optimal deflation. But why then 2% rather than 0% inflation?

Quality and pi star

One argument there is that inflation is overstated due to quality improvements. 2% is really 0%.

The issue: Suppose the iphone 6 turns in to the iphone 7, and costs $100 more. How much of that is inflation, and how much of that is that the iphone 7 is $100 better? Or maybe $200 better, so we are actually seeing iphone deflation? The Bureau of Labor Statistics makes heroic efforts to adjust for this sort of thing, but the consensus seems to be that inflation is still overstated by something like 1-2%.

Some reading on this: The Boskin Commission Report suggested the CPI is overstated by about 1%, as of 1996. Mark Bils, Do Higher Prices for New Goods Reflect Quality Growth or Inflation? argued that it's a good deal more. Mark measured that sales move quickly to new models, which they would not do if it were a price increase after controlling for quality. But Mark's analysis was limited to consumer durables, where quality has been increasing quickly. Many other CPI categories, especially services, are likely less affected.  Philippe Aghion, Antonin Bergeaud, Timo Boppart,  Pete  Klenow and Huiyu Li's Missing Growth from Creative Destruction suggest there is another 0.5%-1% overall because of goods that just disappear from the CPI. (This post all started with discussion following Pete's presentation of the paper recently.)

This is good news. Nominal GDP growth = real GDP growth + inflation. Nominal GDP growth is relatively well measured. If inflation is 1% overstated, then real growth is 1% understated.

It also means our real interest rates are mismeasured. If 2% inflation is really 0% inflation, then 1% interest rates are really +1% real rates, not -1% real rates.

But back to monetary policy. Suppose that 2% inflation is really 0% inflation due to quality effects. Does that mean we should have a 2% long run inflation rate target?

I don't think so. Again, the motivation for a positive inflation target is that there is some economic damage to having to lower prices. But during quality improvements of new goods, nobody has to lower any prices. They are new goods! No existing good has to have lower prices. In fact, actual sticker prices rise.

There is a deeper point here. Not all inflations are equal. One purpose of the CPI is to compare living standards over time. For that purpose, quality adjustments are really important. Another purpose of the CPI is to determine if people have to undergo whatever the pain is associated with lowering prices. For that purpose, quality adjustments are irrelevant.

(On both prices and wages, we also should remember the huge churn. Lots of prices and wages go up, lots go down. The individual is not the average. Changing the average one or two percentage points doesn't change that many individual prices.)

In sum,  the argument that quality improvements mean 2% inflation is really 0% inflation does not argue that therefore the inflation target should be 2% because otherwise people have to lower prices. They don't. Standard-of-living inflation is not the right measure for costs-of-price-stickiness inflation. In price stickiness logic, the Fed should be looking at a CPI measure with no quality adjustments at all!  (At least in this simplistic analysis. This is an invitation to academic papers. If new and old goods are Dixit-Stiglitz substitutes, what are the costs of price stickiness with quality improvements?)
(Update: my correspondent points to "On Quality Bias and Inflation Targets" by Stephanie Schmitt Grohé and Martín Uribe.)

So the argument for a separate inflation target much above zero seems to be weak to me. We're back to Friedman rule vs. headroom, which argues for a direct nominal interest rate target. Since I'm not much of a fan of headroom, I lean to lower values.

Leaving aside price-stickiness, I'm still sympathetic to a price level target on expectations grounds. If the quality adjusted CPI is the same forever, then we have a CPI standard, the value of a dollar is always constant, and long-run uncertainty decreases. We don't shortern the meter 2% every year. For this purpose, we do want the quality-adjusted CPI, and for this purpose the inflation target is primary. An interest rate target would have to rise and fall with r*.

Real rate variation

r* is the real rate. There really is no reason that the "natural" real rate only varies slowly over time. Interest rates crashed in a month 2008 because real rates crashed -- everyone wanted save, and nobody wanted to invest. The Fed couldn't have kept rates at 6% if it wanted to.

So, the procedures used to measure r*, like those used to measure potential output, are a bit suspect. They amount to taking long moving averages, and assuming that "supply" shocks only act slowly over time. More deeply, typical optimal monetary policy discussions use a Taylor rule

         funds rate = r* + 1.5 ( inflation - target) + 0.5 (output gap)

and recommend active short run deviations from the Taylor rule if there are "supply shocks" i.e. r* shocks. Just how the Fed is supposed to distinguish "supply" from "demand" shocks is less clear in reality than the models, which presume shocks are directly visible. A "secular stagnation" fan might say that the moving averages used to measure r* are instead picking up eternally deficient "demand," like a driver with his foot on the brake complaining of headwinds.

Bottom line

As often in policy, we argue too much about the external causes and not enough about the logic tying causes to policy. r* may or may not have declined. But it does not follow that the glidepath nominal rate should be r* plus 2% inflation target. Maybe the glidepath should be 0% nominal rate or 4% nominal rate independent of r*.  You see lots of mechanisms and tradeoffs worthy of modeling.

Nicholas Eberstadt in Commentary, (HT Marginal Revolution) offers a revealing look at what's wrong with "middle" America's stagnation. Read the whole thing, but the following snapshot jumped out at me.

He starts with a review, probably familiar to readers of this blog, of the sharp decline in work rates, even among prime-age men and women.

As of late 2016, the adult work rate in America was still at its lowest level in more than 30 years. To put things another way: If our nation’s work rate today were back up to its start-of-the-century highs, well over 10 million more Americans would currently have paying jobs.

Why are so many not working, not studying for work, and not even looking for work? What is going on in their lives? One answer:

The opioid epidemic of pain pills and heroin that has been ravaging and shortening lives from coast to coast is a new plague for our new century...

According to [Alan Krueger's] work, nearly half of all prime working-age male labor-force dropouts—an army now totaling roughly 7 million men—currently take pain medication on a daily basis.

I think Krueger had a different idea in mind: that they are in pain, indicated by medication, so can't be expected to work. How the explosion in disability jibes with a much safer workplace is an interesting puzzle to that view. Eberstadt has a different interpretation, and the lovely thing about facts is they are facts, not interpretations.

We already knew from other sources (such as BLS “time use” surveys) that the overwhelming majority of the prime-age men in this un-working army generally don’t “do civil society” (charitable work, religious activities, volunteering), or for that matter much in the way of child care or help for others in the home either, despite the abundance of time on their hands. Their routine, instead, typically centers on watching—watching TV, DVDs, Internet, hand-held devices, etc.—and indeed watching for an average of 2,000 hours a year, as if it were a full-time job. But Krueger’s study adds a poignant and immensely sad detail to this portrait of daily life in 21st-century America: In our mind’s eye we can now picture many millions of un-working men in the prime of life, out of work and not looking for jobs, sitting in front of screens—stoned.

(Mark Aguiar, Mark Bils, and Kewin Charles and Erik Hurst have a new paper coming soon, which I just saw presented, "Leisure Luxuries and the Labor Supply of Young Men", with some more facts about time-allocation of non-working young men. They emphasize cheaper and better video games and leave out drugs.)

But how did so many millions of un-working men, whose incomes are limited, manage en masse to afford a constant supply of pain medication? Oxycontin is not cheap. As Dreamland carefully explains, one main mechanism today has been the welfare state: more specifically, Medicaid, Uncle Sam’s means-tested health-benefits program. Here is how it works (we are with Quinones in Portsmouth, Ohio):

"[The Medicaid card] pays for medicine—whatever pills a doctor deems that the insured patient needs. Among those who receive Medicaid cards are people on state welfare or on a federal disability program known as SSI. . . . If you could get a prescription from a willing doctor—and Portsmouth had plenty of them—Medicaid health-insurance cards paid for that prescription every month. For a three-dollar Medicaid co-pay, therefore, addicts got pills priced at thousands of dollars, with the difference paid for by U.S. and state taxpayers. A user could turn around and sell those pills, obtained for that three-dollar co-pay, for as much as ten thousand dollars on the street."

You may now wish to ask: What share of prime-working-age men these days are enrolled in Medicaid? According to the Census Bureau’s SIPP survey (Survey of Income and Program Participation), as of 2013, over one-fifth (21 percent) of all civilian men between 25 and 55 years of age were Medicaid beneficiaries. For prime-age people not in the labor force, the share was over half (53 percent). And for un-working Anglos (non-Hispanic white men not in the labor force) of prime working age, the share enrolled in Medicaid was 48 percent.

By the way: Of the entire un-working prime-age male Anglo population in 2013, nearly three-fifths (57 percent) were reportedly collecting disability benefits from one or more government disability program in 2013. Disability checks and means-tested benefits cannot support a lavish lifestyle. But they can offer a permanent alternative to paid employment, and for growing numbers of American men, they do. The rise of these programs has coincided with the death of work for larger and larger numbers of American men not yet of retirement age. We cannot say that these programs caused the death of work for millions upon millions of younger men: What is incontrovertible, however, is that they have financed it—just as Medicaid inadvertently helped finance America’s immense and increasing appetite for opioids in our new century.

The VA has also been a part of getting veterans addicted to pain killers.

If you dozed off, the main point: Half of non-working prime age men take daily pain medication. Half of non-working prime-age people are in Medicaid, which pays for re-sellable opiates. Three-fifths of non-working prime age Anglos receive disability payments. The latter benefits disappear if you take a job, or if you move, a steep disincentive that Nick does not mention.

I knew the story, but was not really clear on the magnitude. Half.

An advantage of government-subsidized drugs Nick points out: crime is down. However, our criminal justice system offers another barrier to employment and advancement:

...rough arithmetic suggests that about 17 million men in our general population have a felony conviction somewhere in their CV. That works out to one of every eight adult males in America today.

In the understatement of the year,

we might guess that their odds in the real America are not all that favorable.

The bottom line

And when we consider some of the other trends we have already mentioned—employment, health, addiction, welfare dependence—we can see the emergence of a malign new nationwide undertow, pulling downward against social mobility.

Actually looking at people's lives in this way is devastating to the nostrum that "inequality" is mysteriously increasing and just needs more transfers, or its just a lack of "jobs" which can be brought back by left-wing "demand" or right-wing trade restrictions.

people inside the bubble are forever talking about “economic inequality,” that wonderful seminar construct, and forever virtue-signaling about how personally opposed they are to it. By contrast, “economic insecurity” is akin to a phrase from an unknown language.

This is I think an inartful choice of language. I hear "insecurity" a lot from the left, for example just how it is that obese people have trouble paying for food. And, Orwellian language or not, they do have a point. "Insecurity" is not the core of the problem. "Barriers to Advancement" sounds too old fashioned. "Caught in the web of awful disincentives" is more accurate but does not sing.

The abstraction of “inequality” doesn’t matter a lot to ordinary Americans. ...The Great American Escalator is broken—and it badly needs to be fixed.

With the election of 2016, Americans within the bubble finally learned that the 21st century has gotten off to a very bad start in America.

Reading the Weekend New York Times, especially the Review, I think this is actually false. Americans within the bubble are still foaming at the mouth with Trump Derangement Syndrome. But when they get a grip,

Welcome to the reality. We have a lot of work to do together to turn this around.

On Sundays it has been my habit to read the New York Times Sunday Review. I like to peer in the bubble. On view, the old lady is still full-on foaming at the mouth with Trump Derangement Syndrome. Sunday's Review:

1. Our Putin
2. Bring Back Hypocrisy ("The American President and the American Way of Lying") 
3. Donald Trump Will Numb you
4. When it's time to blow the whistle (why leaking Flynn's private phone conversations is ok)
5. Are Liberals Helping Trump?
6. The Secret Service of the Skies (Trump flying is closing down airports.) 
7. New Yalta (Trump, Putin and Xi photoshpped on to Roosevelt, Stalin and Churchill at Yalta) 
8. Being First Lady is a Job (OK, MDS not TDS, but I still count it. ) 
9. Unnamed Sources, Happy Readers (more it's ok to leak private phone calls in service of TDS) 
10. Where in the world can we find hope? "In Canda and Denmark creative strategists fight right-wing populism. "
11. Breaking the Anti-Immigrant fever ("Americans have been watching the Trump Administration unfold for almost a month now, in all its malevolent incompetence...." ) 
12. Trapped in Trump's Brain.
13. How can we get rid of Trump? 
14. Beltway panic, Wall Street Zero? 
15. Diagnosing the President (Is he mentally ill?)
16. Trump's Wall Won't Keep out Heroin.
17. A Muslim Bank is Unscientific.

Frank Diebold, on Mostly Harmless Econometrics:

All told, Mostly Harmless Econometrics: An Empiricist's Companion is neither "mostly harmless" nor an "empiricist's companion." Rather, it's a companion for a highly-specialized group of applied non-structural micro-econometricians hoping to estimate causal effects using non-experimental data and largely-static, linear, regression-based methods. It's a novel treatment of that sub-sub-sub-area of applied econometrics, but pretending to be anything more is most definitely harmful, particularly to students, who have no way to recognize the charade as a charade.

Disclaimer, I haven't read the book. The  quote does summarize feelings I have had in many seminars involving difference in difference in difference regressions with 100 fixed effects and controls. But mostly I post it as a lovely quote.

How can economies forget? How is it that once we have learned to do something better, that knowledge can be lost and economies move backward? How can productivity decline? Viewing productivity as knowledge, it would seem almost impossible for it to do so -- and real business cycle theory was often derided on that point. Yet middle ages eurpoeans lost the recipe for concrete, and time after time we have seen economies get worse. How can our own productivity be growing so slowly overall when so much we see around us is progressing so fast?

Scott Alexander at Slate Star Codex has an intriguing blog post that illuminates these questions (HT marginal revolution). I'll offer my thoughts on the answers at the end.

Scott starts with education:

Inputs triple, output unchanged. Productivity dropped to a third of its previous level.


Scott offers remarkable economic clarity on the issue:

"Which would you prefer? Sending your child to a 2016 school? Or sending your child to a 1975 school, and getting a check for $5,000 every year?

I’m proposing that choice because as far as I can tell that is the stakes here. 2016 schools have whatever tiny test score advantage they have over 1975 schools, and cost $5000/year more, inflation adjusted. That $5000 comes out of the pocket of somebody – either taxpayers, or other people who could be helped by government programs.

...College is even worse. Inflation-adjusted cost of a university education was something like $2000/year in 1980. Now it’s closer to $20,000/year.... Do you think that modern colleges provide $18,000/year greater value than colleges did in your parents’ day? Would you rather graduate from a modern college, or graduate from a college more like the one your parents went to, plus get a check for $72,000?  (or, more realistically, have $72,000 less in student loans to pay off)"

Health care is similarly bloated, though a more complex case.

The cost of health care has about quintupled since 1970. ... The average 1960 worker spent ten days’ worth of their yearly paycheck on health insurance; the average modern worker spends sixty days’ worth of it, a sixth of their entire earnings. 

Unlike schooling, health care is unquestionably better now. Scott notices that lifespan doesn't go up as much as we might have hoped, and other countries get the same lifespan with much less cost. Tell that to someone with an advanced cancer, curable with modern drugs and not with 1970 drugs. Still, it's a good example to keep in mind, as it's pretty clear health care is delivering a technologically more advanced product with a huge decrease in organizational efficiency.

Infrastructure, today's cause célèbre is more telling,

"The first New York City subway opened around 1900. ...That looks like it’s about the inflation-adjusted equivalent of $100 million/kilometer today... In contrast, Vox notes [JC: This is an excellent article worth a blog post on its own] that a new New York subway line being opened this year costs about $2.2 billion per kilometer, suggesting a cost increase of twenty times – although I’m very uncertain about this estimate.

...The same Vox article notes that Paris, Berlin, and Copenhagen subways cost about $250 million per kilometer, almost 90% less. Yet even those European subways are overpriced compared to Korea, where a kilometer of subway in Seoul costs $40 million/km (another Korean subway project cost $80 million/km). This is a difference of 50x between Seoul and New York for apparently comparable services. It suggests that the 1900s New York estimate above may have been roughly accurate if their efficiency was roughly in line with that of modern Europe and Korea."

I have seen similar numbers for high speed trains -- ours cost multiples of France's, let alone China's.

I find this one particularly telling, because we're building 19th century technology, with 21st century tools -- huge boring machines that dramatically cut costs. And other countries still know how to do it for costs orders of magnitude lower than ours.

Similarly, housing. bottom line

"Or, once again, just ask yourself: do you think most poor and middle class people would rather:

1. Rent a modern house/apartment

2. Rent the sort of house/apartment their parents had, for half the cost"

Housing is a little different I think, because much of the cost rise is the value of land, so supply restrictions are clearly at work.

More useful anectdotes, on whether this is real or just a figment of statistics.

The last time I talked about this problem, someone mentioned they’re running a private school which does just as well as public schools but costs only $3000/student/year, a fourth of the usual rate. Marginal Revolution notes that India has a private health system that delivers the same quality of care as its public system for a quarter of the cost. Whenever the same drug is provided by the official US health system and some kind of grey market supplement sort of thing, the grey market supplement costs between a fifth and a tenth as much; for example, Google’s first hit for Deplin®, official prescription L-methylfolate, costs $175 for a month’s supply; unregulated L-methylfolate supplement delivers the same dose for about $30. And this isn’t even mentioning things like the $1 bag of saline that costs $700 at hospitals. 

Where is the money going? It's not, despite what you may think, going to higher salaries:


Scott has similar evidence for college professors, doctors, nurses and so on. What about fancy salaries you hear about?

...colleges are doing everything they can to switch from tenured professors to adjuncts, who complain of being overworked and abused while making about the same amount as a Starbucks barista.

It's also not going to profits, or CEO salaries. Those have not risen by the orders of magnitude necessary to explain the cost disease.

This can’t be pure price-gouging, since corporate profits haven’t increased nearly enough to be where all the money is going.

My thoughts below.

Scott's elegant summary:

So, to summarize: in the past fifty years, education costs have doubled, college costs have dectupled, health insurance costs have dectupled, subway costs have at least dectupled, and housing costs have increased by about fifty percent. US health care costs about four times as much as equivalent health care in other First World countries; US subways cost about eight times as much as equivalent subways in other First World countries.

And this is especially strange because we expect that improving technology and globalization ought to cut costs. In 1983, the first mobile phone cost $4,000 – about $10,000 in today’s dollars. It was also a gigantic piece of crap. Today you can get a much better phone for $100. This is the right and proper way of the universe. It’s why we fund scientists, and pay businesspeople the big bucks.

But things like college and health care have still had their prices dectuple. Patients can now schedule their appointments online; doctors can send prescriptions through the fax, pharmacies can keep track of medication histories on centralized computer systems that interface with the cloud, nurses get automatic reminders when they’re giving two drugs with a potential interaction, insurance companies accept payment through credit cards – and all of this costs ten times as much as it did in the days of punch cards and secretaries who did calculations by hand.

It’s actually even worse than this, because we take so many opportunities to save money that were unavailable in past generations. Underpaid foreign nurses immigrate to America and work for a song. Doctors’ notes are sent to India overnight where they’re transcribed by sweatshop-style labor for pennies an hour. Medical equipment gets manufactured in goodness-only-knows which obscure Third World country. And it still costs ten times as much as when this was all made in the USA – and that back when minimum wages were proportionally higher than today.

And it’s actually even worse than this. A lot of these services have decreased in quality, presumably as an attempt to cut costs even further. Doctors used to make house calls; even when I was young in the ’80s my father would still go to the houses of difficult patients who were too sick to come to his office. This study notes that for women who give birth in the hospital, “the standard length of stay was 8 to 14 days in the 1950s but declined to less than 2 days in the mid-1990s”. The doctors I talk to say this isn’t because modern women are healthier, it’s because they kick them out as soon as it’s safe to free up beds for the next person. Historic records of hospital care generally describe leisurely convalescence periods and making sure somebody felt absolutely well before letting them go; this seems bizarre to anyone who has participated in a modern hospital, where the mantra is to kick people out as soon as they’re “stable” ie not in acute crisis.

If we had to provide the same quality of service as we did in 1960, and without the gains from modern technology and globalization, who even knows how many times more health care would cost? Fifty times more? A hundred times more?
And the same is true for colleges and houses and subways and so on.

Scott points out that many of our intractable political debates -- paying for college, health care, housing, and transportation, are made intractable by this bloat:

 I don’t know why more people don’t just come out and say “LOOK, REALLY OUR MAIN PROBLEM IS THAT ALL THE MOST IMPORTANT THINGS COST TEN TIMES AS MUCH AS THEY USED TO FOR NO REASON, PLUS THEY SEEM TO BE GOING DOWN IN QUALITY, AND NOBODY KNOWS WHY, AND WE’RE MOSTLY JUST DESPERATELY FLAILING AROUND LOOKING FOR SOLUTIONS HERE.” State that clearly, and a lot of political debates take on a different light.

What's happening?

I think Scott's post is exceptionally good because it points out the enormous size of the problem. It's just not salient to point to productivity numbers that grow a few percentage points higher or lower. When you add it up over decades to see that while some things have gotten ten times better, other things are ten times more expensive than they should be really strikes home.

Scott tries on a list of candidate explanations and doesn't really find any. He comes closest with regulation, but correctly points out that formal regulatory requirements, though getting a lot worse, don't add up to the huge size of this cost disease.

So, what is really happening? I think Scott nearly gets there. Things cost 10 times as much, 10 times more than they used to and 10 times more than in other countries. It's not going to wages. It's not going to profits. So where is it going?

The unavoidable answer: The number of people it takes to produce these goods is skyrocketing. Labor productivity -- quality adjusted output per number of people involved in the entire process -- declined by a factor of 10 in these areas. It pretty much has to be that: if the money is not going to profits, to to each employee, it must be going to the number of employees.

How can that happen? Our machines are better than ever, as Scott points out. Well, we (and especially we economists) pay too much attention to snazzy gadgets. Productivity depends on organizations not just on gadgets. Southwest figured out how to turn an airplane around in 20 minutes, and it still takes United an hour.

Contrariwise, I think we know where the extra people are. The ratio of teachers to students hasn't gone down a lot -- but the ratio of administrators to students has shot up. Most large public school systems spend more than half their budget on administrators. Similarly, class sizes at most colleges and universities haven't changed that much -- but administrative staff have exploded. There are 2.5 people handling insurance claims for every doctor. Construction sites have always had a lot of people standing around for every one actually working the machine. But now for every person operating the machine there is an army of planners, regulators, lawyers, administrative staff, consultants and so on. (I welcome pointers to good graphs and numbers on this sort of thing.)

So, my bottom line: administrative bloat.

Well, how does bloat come about? Regulations and law are, as Scott mentions, part of the problem. These are all areas either run by the government or with large government involvement. But the real key is, I think lack of competition. These are above all areas with not much competition. In turn, however, they are not by a long shot "natural monopolies" or failure of some free market. The main effect of our regulatory and legal system is not so much to directly raise costs, as it is to lessen competition (that is often its purpose). The lack of competition leads to the cost disease.

Though textbooks teach that monopoly leads to profits, it doesn't "The best of all monopoly profits is a quiet life" said Hicks.  Everywhere we see businesses protected from competition, especially highly regulated businesses, we see the cost disease spreading. And it spreads largely by forcing companies to hire loads of useless people.

Yes, technical regress can happen. Productivity depends as much on the functioning of large organizations, and the overall legal and regulatory system in which they operate, as it does on gadgets. We can indeed "forget" how those work. Like our ancestors peer at the buildings, aqueducts, dams, roads, and bridges put up by our ancestors, whether Roman or American, and wonder just how they did it.

In 2017, we have five meet-ups scheduled, as well as the annual Irish economics and psychology workshop on December 1st:

9th February: Behavioural Economics and the Ethics of Influence (sign-up here)
31st March: Professor Cass Sunstein Public Lectures in UCD and ESRI
18th May: Field, Lab, and Natural Experiments in Public Policy (sign-up here)
7th September: Behavioural Economics and Communications in Policy and Business (sign-up here)
19th October: Behavioural Economics and the Future of Regulation (sign-up here)
1st December: 10th Annual Economics and Psychology Conference (sign-up here)