Economist Channel

"Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks" is an interesting new paper by  Greg Buchak, Gregor Matvos, Tomasz Piskorski, and Amit Seru

1. Shadow banks and fintech have grown a lot.

the market share of shadow banks in the mortgage market has nearly tripled from 14% to 38% from 2007-2015. In the Federal Housing Administration (FHA) mortgage market, which serves less creditworthy borrowers, the market share of shadow banks increased...from 20% to 75% of the market. In the mortgage market, “fintech” lenders, have increased their market share from about 5% to 15% in conforming mortgages and to 20% in FHA mortgages during the same period

2. Where are they expanding? They seem to be doing particularly well in serving lower income borrowers -- FHA loans.  They also can charge higher rates than conventional lenders, apparently a premium for convenience of not having to sit in the bank for hours and fill out forms,

Consider Quicken Loans, which has grown to the third largest mortgage lender in 2015. The Quicken “Rocket Mortgage” application is done mostly online, resulting in substantial labor and office space savings for Quicken Loans. The “Push Button. Get Mortgage” approach is also more convenient and faster for internet savvy consumers....

Among the borrowers most likely to value convenience, fintech lenders command an interest rate premium for their services. 

They also specialize in refinancing

Sector shadow banks have gained larger market shares in the refinancing market relative to financing house purchases directly. One possible reason for this segmentation is that traditional banks are also substantially more likely to hold loans on their own balance sheet than shadow banks. Approximately one fourth of traditional banks loans in HMDA are held on their own balance sheet. For shadow banks, the share is closer to 5%. Because refinancing loans held on the balance sheet cuts directly into a bank’s profit, their incentives to refinance are smaller..

This is a really cool point.

Our mortgage system is based on a rather crazy product, the fixed rate mortgage with a costly option to refinance. No other country does this. I know a lot of finance professors, and none of them can tell you the optimal refinancing rule. (It takes a statistical model of the term structure of interest rates and a complicated numerically solved dynamic program.) A lot of the system seems to be price discrimination by pointless complexity, a disease that permeates contemporary America.

Banks are on the other end of this. The bank holding your mortgage doesn't want you to refinance -- it wants you to keep paying the higher interest rate.  Unless, that is, it can get you to refinance too early and charge a lot of fees for it.  The natural product would be a automatically refinancing mortgage, in which a computer program automatically gives you a lower rate when it's time. It's not hard to figure out why banks don't offer that. In a competitive market, then, a third company would come in and offer refinancing, forcing the banks' hands. Competition is always the best consumer protection. And that seems to be exactly what we're seeing here.

3. Forces. A really good part of the paper (take notice economics PhD students) is how it teases out casual effects. I won't cover that in detail to keep the post from growing too long. A paper is not about its "findings" in the abstract, but the facts and logic in the paper. Some hints of the evidence follow.

To what extent are shadow banks and fintech stepping in to fill regulatory constraints, and to what extent is it just technology?

a) Some is technology, seen by this comparison.

Fintech lenders, for which the origination process takes place nearly entirely online... By comparing .. fintech and non-fintech shadow banks, we compare lenders who face similar regulatory regimes, thus isolating the role of technology. First, we find some evidence that fintech lenders appear to use different models (and possibly data) to set interest rates. Second, the ease of online origination appears to allow fintech lenders to charge higher rates, particularly among the lowest-risk, and presumably least price sensitive and most time sensitive borrowers.

In an otherwise cautious paper, I think this goes much too far. If a private securitization market existed, as it did before 2008, could shadow banks sell to them? Is the demise of private securitization just because the government killed it with the taxpayer subsidy implied by government guarantees? Absent guarantees would we just have a private industry that costs 20 basis points more? Just because finch now sells to government-guaranteed securitizers does not mean it must sell that way.

c) But the elephant in the room -- are shadow banks filling in where regulations keep transitional banks from going?

Unlike shadow banks, traditional banks are deposit taking institutions, and are thus subject to capital requirements, which do not bind shadow banks. If capital requirements are the constraint that increases the cost of extending mortgages for traditional banks, we should see larger entry of shadow banks in places in which capital requirement constraints are more binding. Indeed, we find a larger growth of shadow banks in counties in which capital constraints have tightened more in the last decade

In case you missed the point,

By comparing the lending patterns and growth of shadow bank lenders, we demonstrate shadow bank lenders expand among borrower segments and geographical areas in which regulatory burdens have made lending more difficult for traditional, deposit-taking banks.

"..the additional regulatory burden faced by banks opened a gap that was filled by shadow banks. "

We argue that shadow bank lenders possess regulatory advantages that have contributed to this growth. First, shadow bank lenders’ growth has been most dramatic among the high-risk, low-creditworthiness FHA borrower segment, as well as among low-income and high-minority areas, making loans that traditional banks may be unable hold on constrained and highly monitored balance sheets. Second, there has been significant geographical heterogeneity in bank capital ratios, regulator enforcement actions, and lawsuits arising from mortgage lending during the financial crisis, and we show that shadow banks are significantly more likely to enter in those markets where banks have faced the most regulatory constraints.

4. Policy

The paper is very careful not to make policy implications. I am under no such limitation.

It is too easy to take the last point and conclude "Regulations are hurting the banks! Get rid of them so banks can get their business back!" But that does not follow (which is a good reason the paper does not say it!)

Banks have capital and risk regulations because they fund their activities with deposits and short term debt. Those liabilities are prone to runs and financial crises. So in fact, one can come to quite the opposite conclusion:

The rise of fintech proves that there is no essential economic tie between loan origination and deposits or other short-term financing 

(Italicized because this is an important point at the end of a long post.) Maybe we want the crisis-prone traditional banking model to die out where it is not needed!

Update: Pedro Gete and Michael Rehr also find government-sponsored securitization helps the rise of fin-tech.

George Shultz and Martin Feldstein, in the Washington Post

If a country consumes more than it produces, it must import more than it exports. That’s not a rip-off; that’s arithmetic. 

If we manage to negotiate a reduction in the Chinese trade surplus with the United States, we will have an increased trade deficit with some other country. 

Federal deficit spending, a massive and continuing act of dissaving, is the culprit. Control that spending and you will control trade deficits.

That's not an excerpt, it's the whole thing. Someday, I will learn to be this concise.

Holman Jenkins and Cliff Asness have worthy commentaries on the health insurance reform effort.

Jenkins has quite a few fresh thoughts. He also gets the incurable optimist award for viewing the bill as the "inklings of a salvation" for America’s health-care system. It's possible. Whether it is likely depends on your views of the political process.

Individual insurance:

Jenkins' freshest thought comes last:

We’ll say it again, now for the Senate’s benefit: Apply a few GOP-style fixes and ObamaCare, or something like it, becomes a solution to America’s health-care muddle. You could phase out every other federal program, including Medicare, Medicaid and the giant tax handout to employers, and roll their beneficiaries into ObamaCare.

This wisdom is exactly the opposite of most current commentary, and, here in grumpy-land, where it seems the political process may be heading.

Yes, if any memory of markets remains, the goal should be to get everyone on individual insurance -- functional, portable, individual, lifetime, guaranteed-renewable, competitive health insurance, married to mercilessly competitive innovative and disruptive health care supply. People who need help -- sick and poor -- get it by subsidies to buy that insurance. Period. (Newcomers, some of my many writings on this topic are here.)

I fear we are going in the opposite direction. I fear that the non-subsidized individual market is going to shrink more and more, to become more and more an insignificant, government run, dysfunctional waystation for a handful of unlucky self-employed and young people, on their way to employer care, a government program (medicare, medicaid, VA, etc.) or now to a miserly high-risk pool.


Most of the Obamacare expansion of coverage was into medicare, or by people getting premium subsidies on the exchanges, and by pressure for expanded employer-basded coverage. The market of people paying actual premiums for individual insurance remains tiny.  Commenters point out the apparent pathology that Congress is wasting so much time on a tiny sliver of the population, how most of us have "just fine" coverage through employers, medicare, medicaid, VA, government employee plans, retiree plans, and so on. As if this is the right way to run things.

Parts of the Republican bill do seem helpful towards reviving the individual market. The vision that we should all be there, as we are all in the individual home, auto, and life insurance market; as well as the vision that the central problem is a supply system made dysfunctional by cross-subsidies and resultant anti-competitive limitations, I don't see yet in the legislative proposals and surrounding commentary.  That is a bad sign for the politics of Jenkins' (and my) vision. It is not ignorance. My impression is that most people involved understand the promised land perfectly well, they just don't think it can get two votes in the senate, let alone 51 or 61.

Mandate

Jenkins offers equally fresh thinking on the mandate

...In a world where individual insurance is fairly priced, a mandate would be less burdensome. As candidate Obama said in 2008, with a smidgen of hyperbole, if health insurance is a good deal, nobody would need to be forced to buy it. 

...The philosophical premises of the Republican and Democratic individual mandates could not be further apart. The original Republican mandate, hatched by the Heritage Foundation in 1989, was aimed at making sure would-be free riders paid their fair share, no longer transferring their financial risk to the taxpayer or other health-care consumers. 

ObamaCare turned the mandate into a tax—a way to overcharge the young, healthy and (let’s face it) male to generate funds to subsidize voter blocs Democrats wanted to subsidize.

The economic argument for a mandate of the Heritage type is pretty strong, as we have mandates for auto insurance. Given that we are not going to allow people to die in the gutter, then a mandate protects the finances of such government-provided charity care (or government mandated cross subsidies) to require that everyone has at least bare-bones catastrophic coverage, to cover... well, whatever it is that we are not willing to say "no" to when they show up on the hospital doorstep. Which is a lot.

Even that argument for a mandate is quite limited. We don't let people die, or suffer untreated illness. But there is much less case that we should not be willing to bankrupt the improvident. Even Sweden and Denmark do that. If you don't buy health insurance and get a heart attack, the government and hospitals should happily burn through your bank account.  And then you get the care you need. The economic mandate really is really only needed for people with few resources, or who can't get around to filling out forms (a lot of us).

And, yes, the economics of insurance is ex-post transfers. Those who turn out to be healthier than expected, ex-post transfer resources to those who turn out to be sicker than expected.

But, Jenkins' great insight is, look how these valid economic arguments utterly perverted in the political system.

Neither the economic mandate, nor insurance itself, is the basis for massive, completely predictable transfers from one group to another. Under Obamacare, individual mandates, insurance mandates, and "community" rating turned in to a massive transfer from (as he put it) "the young, healthy and (let’s face it) male to generate funds to subsidize voter blocs Democrats wanted to subsidize." That is clearer in this weekend's other commentary. See Ross Douthat in the Times review section, for example), focusing on "tax cuts for the rich;" and commentary focusing on how it will "hurt old people" -- both taxes and handout to old people, only enacted with Obamacare, now apparently baked in stone. All this unitentionally makes Jenkins' point. This isn't about health insurance anymore. It's just redistribution.

Also, the trope of how millions will now be "denied access to health care" (once again confusing insurance and care). Actually, 10 million of the CBO scoring that the Republican plan would lead to millions losing coverage came down to the mandate. 5 million of that are  people eligible for Medicaid who, the CBO thinks, will simply not bother to sign up even for free insurance without the mandate.

ObamaCare went out of its way to be a bad deal for the young and healthy, who didn’t sign up. The GOP fix [5:1 premiums, much less mandated coverage], if adopted in the Senate, would go a long way toward letting individual premiums be fairly and attractively priced to these people.

It would. Sadly, coverage of what's going on in the Senate, covered say in the same WSJ issue "Senators tackle heath bill rewrite" will undo modest progress:

Among the provisions senators are tackling is one that allows insurers to charge older Americans five times as much as younger people and lets states obtain waivers that could make that disparity even larger. 

That old people are more expensive to care for than young people is not an insurable risk. Old people per se are not necessarily deserving of cross-subsidies. Old, poor people are, but because they're poor not because they're old. Most non-poor old people own a house, which they have paid off, and substantial assets.  Most wealth in the economy is owned by old people. Old people have lower expenses.  Limiting the ratio of young to old in mandated insurance is just one huge cross-generational transfer of wealth. (On top of, I might add, social security, which is an enormous transfer from the current young to the current old. The current young are not going to get such generosity when they get old.) The supreme court had it half right -- the mandate is a tax. The big tax is the "community rated" overpriced insurance.

Jenkins again: If we had universal individual insurance, and helped people by subsidizing its purchase,

Congress could start making rational judgments about whom to subsidize and whom not to subsidize. Do all seniors need a handout, or only the poor ones? [Or only the sick ones?] And surely no Congress would re-up to the current employer tax benefit, which gives its biggest handout to the highest earners while producing all the pathologies the employer-centric payment system is heir to.

Is that a typo? Surely no Congress should reup, or perhaps could, but I see no signs that no Congress  would.  The tax deduction for employer provided health payment plans seems as rooted as the equally silly and damaging tax deduction for mortgage interest.  (And kudos to WSJ for coming out against that one in the lead editorial.) The proposal to also exempt individual insurance payments from taxes at least undoes some damage by putting both on the same footing.

Why cross subsidize wealthy seniors so much? Well, they vote. And they vote Republican. Given that, it's amazing that the house even tried to put in 5:1 in favor of Bernie-Sanders voting youth.

In case you missed it, the tax deduction for employer provided group coverage, but not for employer or employee contributions to an individual portable plan, really is the original sin, or the fly that the little old lady swallowed on her way to death from horse. Preexisting conditions follow entirely from that -- who will pay for lifelong guaranteed renewable insurance if they plan to get a job and throw it away? People who get sick and leave their jobs are stuck. Well, solve that with community rating, guaranteed issue, forced cross-subsdies, limits to competition.. and here we are.

Preexisting conditions. 

In principle, this should be a transitional problem in a world where everyone has access to attractive, fairly priced health insurance. By giving new options to the states, the House bill would make subsidizing pre-existing conditions a general obligation of the taxpayer as it always should have been.

So far so good. To amplify, in a portable, individual, universal, guaranteed-renewable competitive market, there is no preexisting conditions problem. But to get there, especially after Obamacare wiped out the existing guaranteed-renewable individual insurance, people currently sick are going to need an on-ramp. In Jenkins' optimistic view, the state high risk pools are such a transitory device. Jenkins is absolutely right that we need some transitory device.  By forcing cross-subsidies to give the illusion we are not taxing and spending, we achieve less at much greater cost.

I would prefer (as he might) a vibrant unconstrained competitive insurance market; that market would have guaranteed issue, but because insurers are allowed to charge any price so they will happily serve and compete for any customer without coercion. Then high risk pools subsidize the high premiums that people already sick have to pay, until we realistically can expect everyone to have bought guaranteed-renewable insurance before they got sick.

A good principle is that transitory devices need not be perfect. Another good principle is that imperfect transitory devices should be transitory.

However, with the portable, individual, universal, guaranteed-renewable competitive market nowhere in sight, I fear that this "transitional" problem is going to be semi-permanent.

What happened to portability, the long promise that you can buy insurance across state lines?
State-based high risk pools are going to make it even harder for people to move from state to state. State-based insurance already does this to some extent. Under Obamacare the conceit was, with guaranteed issue and community rating, anyone could move, and just get insurance in the new state. That was never easy in practice. (Actually trying to buy individual insurance that covers anything, as we did for a daughter over 26, is a salutary exercise.)

In sum, I worry as advertised at the outset, that we are headed to a permanent state that the government runs ever expanding mediare, medicaid, VA, and so forth; employer-based group coverage is forever ensrhined, and the market for individual insurance of people actually paying premiums becomes completely dysfunctional, now really providing only catastrophic coverage for a tiny group of people who are essentially uninsured until they become sick, at which point they are transferred to a government provided high risk pool. The transitory has a way of becoming permanent.

Here I think Jenkins makes one tiny mis-step:

Republicans...wussed out with a semi-mandate, in which anybody who lets coverage lapse and then tries to re-enter the system will pay a penalty.

No, that is not a semi-mandate! That was one good step on the way to guaranteed renewable coverage. You buy health insurance not so that "someone else" will pay for your predictable expenses, and not so much for the chance that you might have a catastrophe this year. You buy health insurance so that if you get sick, you can still buy health insurance next year!  You should face a healthy incentive to stay insured. The imperfection of the Republican plan is that it limited the penalty (insurers would charge larger penalties for those who lapsed coverage, and could not charge more than 5:1) not that it imposed a penalty.

However, sometimes half step may not work half as well as a whole step. In a true GR system, if you drop out, and fail even to purchase the option to buy insurance later, then you get sick, you will be charged the full newly rated price. That's the only way to have insurers voluntarily cover you, without cross-subsidizing from someone else, and thus without banning competition. In that case you always have an incentive to sign up, quick, before you get even sicker. With a fixed and capped penalty for signing up again, now you have no incentive to hurry. You're going to pay the same penalty no matter how sick you get or how long you wait. So critics are right that a new group of people waiting to get really sick before they sign up again and pay the penalty will crop up.

Asness

If all of this is depressing you and you want a good old romp through free market heath care and reform, read Cliff Asness 

Myth #2:  The pre-ObamaCare system was ‘insurance’ 

It was not a system of insurance. Insurance, as practiced everywhere else but healthcare, is about catastrophes. What we had was a government-subsidized payment plan funneled through insurance companies. 

... Due primarily to the tax subsidy given to employer-provided healthcare (a bipartisan, so-far-untouchable disaster), catastrophic health insurance is not Americans’ norm. Rather, employers provide essentially all healthcare from basic health maintenance and symptom relief to the most expensive life-saving procedures, and they do it because the government massively subsidizes this approach. 

This is odd. You don’t go to your car insurer to fill your car with gas or to your homeowner’s insurance company to change a light bulb. Why do you go to your health insurance company for everyday medical services? That is not insurance, it is tax-subsidized provision of all your healthcare needs, and it causes two of our system’s biggest problems. 1) Health coverage is not portable, as it’s employer-provided, and 2) consumers are insulated from the cost of basic healthcare because they don’t pay directly for services. Educated consumers spending their own money would be far better shoppers for healthcare. ...Paying $5 for a prostate exam is demeaning to both parties. 

Myth #3: Stopping insurance companies from charging based on pre-existing conditions is the one good part of ObamaCare 

Even many Republicans fall for this one, perhaps because it polls well. In these days of horrible discord, partisanship, and uncivil discourse (actually very much like the other 200+ years of the Republic) it is nice to know we can all still get together to rally around a really dumb idea....

It goes on like this. Go read the original.

Final political thoughts

You will notice that I'm not really getting in to the weeds on the Republican plan, and you may be disappointed by a lack of close analysis.  I've written here at length about how health insurance and health care (for the last time, not the same thing!) should be fixed. There is no point in repeating that.  The plan has lots of steps in the right direction.  But to score it by economic purists' standards is unfair and unproductive.  The Republican plans are clearly crafted by what the leaders think they can get through politically. Score them as such -- and from my limited knowledge of politics, they strike me as bloody brilliant given the current situation of a narrow majority in the Senate, "resistance" close to "rebellion" from the other side, and nobody really in fear of the President or party discipline. This really isn't an economic issue at this point. If they can get a few steps in the right direction, show they can govern, and set the stage for more comprehensive reform later, there is hope.

Jenkins adds

P.S. Don’t kid yourself that Democrats have a plan other than blindly defending more and more subsidies for more and more health-care consumers. Single-payer is not a plan. It’s an invitation for the health-care industry—doctors, hospitals, the research establishment—simply to turn their full attention to serving the self-paying rich.

As so much of America, the veneer of government concern for common people leads instead to private schools, gated communities, private jets, and soon concierge doctors and hospitals for the 1%, those with connections, and the Washington elite. And lousy public schools, public transport, and coming soon lousy health care for the rest.

A charming animated free-market poem by Russ Roberts, on the invisible hand, at http://wonderfulloaf.org

The "read the poem" link includes much interesting annotation.

Mild critique: I would rather the "planner" be a well-meaning economist faced with impossible information problems than a darkly sinister white guy in a suit. It looks like all we need is better  planners. And the bakers seem really happy about all that competition and free entry, whereas real bakers quickly band together to demand regulation, occupational licensing, and other restrictions. But I'm just whining, it's a good romp through the invisible hand in a mythic war-free and Disney-clean 1940s Europe.

UCD School of Economics is pleased to announce a call for applications for the 2017-18 PhD Scholarship scheme. The aim of the scheme is to attract applicants of the highest academic standards to participate in the UCD School of Economics PhD programme (details here) and provide them with the training, experience and mentorship necessary to their professional development.

These PhD Scholarships will comprise an annual tax-free annual stipend of between €12,000 and €15,000 plus a full waiver of fees. The scheme is open to both new applicants and existing PhD students, with the understanding that the stipend and fee waiver will continue to be provided to students up to and including their fourth year of PhD studies, subject to their continuing to make satisfactory progress in their studies and meeting the terms and requirements of their scholarship.

Students in receipt of a Scholarship are required to work as tutors in either undergraduate or graduate modules taught by the School of Economics. This will allow PhD students to develop the practical application of their academic skills by ongoing training and experience of tutorial teaching, assessment and pedagogical development. This taught component will amount to no more than 50 hours of teaching during each of our 12-week teaching semesters.

A selection board of School of Economics faculty members will review applications and make its recommendations on selection to the Head of School. Applications will be evaluated and ranked by the Selection Board according to the following criteria:
Academic excellence (transcripts, previous research experience, etc.)
The academic testament of referees;
Quality and clarity of the research proposal;
Fit with the research strengths of the School;
Teaching potential (past teaching experience, English proficiency, etc.);
Availability of other funding to applicant (such as Irish Research Council awards).

Complete applications must be submitted on or before 18 May 2017. New applicants who are short-listed for a scholarship will then be contacting for a short interview, either in person, via phone, or via computer (such as Skype). The school will then conduct interviews with each finalist, either in person, via phone, or via the computer (such as Skype). Scholarships will be awarded on approximately May 31, 2017. Successful applicants have until 15 June 2017 to notify the school of their decision whether or not to accept the scholarship. Additional scholarships may be awarded in June or July depending on availability.

For students who are unsuccessful in applying for a PhD scholarship, the school also offers other forms of financial assistance, including fee waivers, hourly tutoring contracts, and marking exams.

If you are interested in applying for these scholarships, please review the associated terms and conditions carefully.

Click here for the application form. Completed forms should be emailed to economics@ucd.ie

Click here for the terms and conditions for the scholarships.

In case you missed it, this Sunday featured a creditable effort by the NY Times to look out of the groundhog hole. You have likely followed the explosion resulting from Bret Stephens' first column. Likewise, Ross Douthat tried to explain the attraction of Marine LePen.  I'm not a LePen fan, but appreciated his honest effort to explain how the other side say things.

I was interested in Douthat's views on the euro:

But on the other hand, our era’s “enlightened” governance has produced an out-of-touch eurozone elite lashed to a destructive common currency,..

There is no American equivalent to the epic disaster of the euro, a form of German imperialism with the struggling parts of Europe as its subjects... 

And while many of her economic prescriptions are half-baked, her overarching critique of the euro is correct: Her country and her continent would be better off without it.

Douthat does not pretend to be an economist, and I have no beef with his expressing such views. Because such views are commonplace conventional wisdom from our policy elite. And if the euro falls apart, they will bear a lot of blame for its passing. Be careful what you write, people might be listening.  No, when Germany sends Porsches to Greece in return for worthless pieces of paper, it is not Germany who got the better of the deal. And while you're at it, get rid of that silly common meter, and restore proper nationalism of weights and measures too. (Of course perhaps my admiration for the euro is wrong. Then they will deserve credit for the wave of prosperity that flows over Europe once it unleashes the shackles of the common currency dragging it down. )

As a concrete example, consider  Martin Feldstein writing in the Il Sole series on the Euro, (I don't mean to pick on Feldstein. He has been a consistent anti-euro voice, arguing the great benefits for Italy and Greece of periodic inflation and devaluation. But he is just a good sober example of the common view in Cambridge-centered economic policy circles.)


Topic sentences:

Although Italy was an enthusiastic adopter of the euro when the single currency began, the Italian experience of the past decade suggests that was a mistake.

...it seems plausible that Italy’s economy would be in better condition today if Italy, like Britain, had decided to keep its own currency and therefore to be able to manage its own monetary policy and its own exchange rate.

Analysis:

Advocates of adopting the euro argued at the time that members of the Eurozone would be forced by market pressures to converge to a high common level of productivity and a corresponding level of real wages. That never happened. Instead, Germany powered ahead with rising productivity that has resulted in real per capita income 30% higher than Italy’s, an unemployment rate that is less than half Italy's and a trade surplus that is 8 % of its GDP.

Huh? It is a new proposition in monetary economics to me that adopting a common currency forces countries to move to common productivity, any more than adopting the meter forces countries to do so.  Alabama and California share a currency and not productivity. Fresno and Palo Alto share a currency and not productivity.   A common market in products with free movement of capital and labor might force out economic, legal, and regulatory inefficiency, but that would happen regardless of the units of measurement.

The most basic proposition in monetary economics: The choice of monetary unit has no effect on long-run productivity or any other aspect of the long-run real economy. Using the euro vs. the lira has no effect on long-run productivity, any more than using the meter forces Italian tailors to cut Norwegian-sized suits, or that using the Kilo forces Italian restaurants to serve bratwurst and beer rather than pizza and wine.

The countries that adopted the euro never satisfied the three conditions for a successful currency union: labor mobility, flexibility of real wages, and a common fiscal policy that transfers funds to areas that experience temporary increases in unemployment.

This is another repeated truism. In my view the main condition for a currency union was present in the euro and the problem was forgetting about it when the time came. In a currency union without fiscal union, bankrupt governments default just like bankrupt companies. Neither labor mobility (which exists in Europe), flexibility of real wages (doubtful in the US) or common fiscal policy (also limited in the US) are necessary. Europe lived under a common currency -- the gold standard -- for hundreds of years. Sovereigns defaulted.

I suspect Feldstein means by "common currency" far more than I do. I mean, we agree to use a common currency. I suspect Feldstein means far more than that, including that no government debt may ever default and that the ECB must print money to ensure that fact. Like all disagreements perhaps this one simply reflects a difference in meaning of the words. If so, it would be good to say so. Objections to "the euro" are not objections to a common currency per se, but objections to the rest of the legal, regulatory, banking, fiscal, and policy framework that accompanies the euro.

To be fair, there is also a different underlying world view here. In Feldstein's world, national governments and central banks can be relied on to diagnose "shocks," and artfully devalue currencies just enough to "offset shocks" when and only when needed; in the european case likely imposing "capital controls" as well, but to do this rarely enough that investors will still buy government bonds, invest in their countries, and avoid the slide to banana republic inflation, repression, and trade and investment closure. In my world, as I think in the real world of Italy and Greece before the euro, national currencies are not such a happy tool of benevolent dirigisme. The commitment not to devalue, inflate, and grab capital after the fact is good for growth and investment before the fact. A government sober enough to use Feldstein's tools wisely is also sober enough to borrow wisely when offered low rates. A government not sober enough to borrow wisely when offered low rates is not sober enough to artfully devalue, inflate, grab capital "just this once" in response to shocks.

Arnold Kling's Askblog quotes Robert J. Mann

Wal-Mart’s application to form a bank ignited controversy among disparate groups, ranging from union backers to realtor’s groups to charitable organizations. The dominant voice, though, was that of independent bankers complaining that the big-box retailer would drive them out of business. Wal-Mart denied any interest in competing with local banks by opening branches, claiming that it was interested only in payments processing. Distrusting Wal-Mart, the independent bankers urged the FDIC to deny Wal-Mart’s request and lobbied state and federal lawmakers to block Wal-Mart’s plans through legislation. Ultimately, WalMart withdrew its application, concluding that it stood little chance of overcoming the opposition.

Mann also writes

... I argue that permitting Wal-Mart to have a bank would have a salutary effect on the relatively uncompetitive market for payment networks. The dominant position of Visa and MasterCard, in which payments are priced above cost to subsidize credit, inevitably will give way to a world in which payment services are priced at cost, or even below cost as a loss-leader to attract customers to other goods and services.  

As the first quote shows, Walmart was only trying to process payments more efficiently -- because it already saw the chance to offer banking services, lend, and other banking functions would be blocked.

Arnold also points to this by Lawrence J. White.

Arnold sums up,

We are always told that we need regulation to protect consumers and make the financial system safer. That is the theory. The practice is that regulation very often gets used to limit competition. 

Many people in the US still do not have regular bank accounts, and perhaps wisely so as banks notoriously suck money from poor people with pesky fees. Yet cashing a social security check remains a problem. Imagine small town America in which Walmart also offers banking services.

If it's not obvious, Walmart banks would be much safer than traditional banks. A bank tied to a huge retailer would not be financed by astronomical leverage, and if the bank lost money the equity holders of Walmart would pick up the losses.

Walmart has also faced a lot of resistance and restrictions in opening clinics. Imagine small town America in which simple, cheap Walmart clinics can offer a much wider range of services.

It's worth remembering how much opposition Walmart already overcame. It was the Uber of its day. A&P, its predecessor, was widely opposed, as was Walmart. Walmart still faces union opposition -- as I left it was still blocked from operating in the city of Chicago. Imagine the south side of Chicago populated with Walmarts, Walclinics and Walbanks! Thank its legislators and regulators for protecting its citizens from that nightmare.

Update:

An excellent blog post by Larry White on Walmart's troubles in starting a bank. A primary obstacle is the rule that bank holding companies can't be engaged in "commerce." Larry also points out just how much the other banks use this to keep out competition.

the Dodd-Frank Act of 2010 placed a three-year moratorium on the granting of deposit insurance to any new (or newly acquired) ILC. Although the moratorium expired in 2013, bank regulators appear to have “gotten the message” that the commerce-finance barrier should remain intact.

In the WSJ, The 93 Words That Could Unlock $200 Billion in Bank Capital. This could be a great MBA final exam. Spot the errors: 

"Tucked inside a nearly 600-page legislative proposal to overhaul U.S. financial regulations are 93 words that could provide a windfall for bank investors seeking heftier dividends and share buybacks."

"Bank analysts at Barclays BCS -6.08% PLC estimate $236 billion in capital is tied up in operational risk at the four biggest U.S. banks alone"

"Bankers ... want to free up capital that could be returned to shareholders or used for more lending."

"Mr. Dimon added that U.S. banks now hold about $200 billion in capital against operational risk."

(I made it easier with italics, all mine.)

Windfall? When a company pays out dividends, the stock price goes down exactly by the amount of the dividend payment.

Capital is not tied up. Capital is a source of funds, not a use of funds. Capital is equity investment in the bank -- people give the bank money, in return for a stream of dividends.  Capital is not reserves -- cash lying around the vault.

Capital is already used for lending!  Banks get money from equity holders, bond holders, and deposits, and lend it out. Capital requirements are about the ratio of sources of money. (At best, lower capital requirements would allow banks to borrow more money without issuing more equity to lend. If they wanted to.) Capital is not reserves.

No bank "holds" capital, and I hope Mr. Dimon didn't actually say that, as much as he would like lower capital requirements. Capital is not "held" like reserves.

This article does reflect nicely the total level of confusion in the debate about banking regulations. Colleagues contemplating clever complex schemes, take note.

The purpose of this post (which I am updating from time to time) is to start a discussion online and in the research centre about historical works (say pre-1960) that are most worthwhile to read for people interested in contemporary behavioural science and behavioural economics debates. The remit is probably too broad to be wholly coherent but if it leads to some good suggestions for reading that people had not considered before then it is worth doing. Works from centuries or millenia before often have a way of having a recurring influence on modern fields not least evidenced by the recent renewed interest in Aristotle and Greek concepts of well-being in the modern literature. Would be good to get suggestions from people in the comments, by email, in person.

Aristotle's Nichomachean Ethics is clearly a key reference work from antiquity. Will add more on this at a later stage.

Nico Machiavelli's The Prince contains a wealth of insights into influence in the context of complex governance issues.

Adam Smith's The Theory of Moral Sentiments. See also this article on Adam Smith's pedigree as a behavioural economist. A more general tour of the Scottish Enlightenment's role in the development of disciplines such as Economics would be interesting for a future post and/or walking tour. David Hume's Treatise on Human Nature contains a wealth of ideas that are relevant to modern academic debates on decision making, valuation, causality and so on. See this link for a short blogpost I wrote on the Treatise and modern behavioural economics. Thanks to @cathyby on twitter for repeated reminders on the importance of Francis Hutcheson and also the recommendation to include Bernard De Mandeville. The latter's Fable of The Bees is cited across many areas of Economics.

Pretty much anything from JS Mill in particular On Liberty, The Principles of Political Economy and Utilitarianism. Obviously also Bentham.

Emile Durkheim is a forerunner of many literatures relevant to readers here. A very useful UChicago webpage on his work here.

Simmel's Philosophy of Money is often  cited as a historical reference in modern papers on economic psychology. It deals with a staggering array of questions on the philosophy and implications of using money as the medium of exchange.

Schumpeter's History of Economic Analysis would be one of my desert island books. I once ran an informal book club over several sessions on this work. Contains a wealth of information on the many interesting characters that populated debates on issues such as the correct notion of utility over the centuries.

From Schumpeter, the importance of the German Cameralist movement becomes apparent in particular Johann Justi. Many elements of modern thinking about the state improving the health and welfare of citizens in an economic framework come from this movement. Thanks to Charles Larkin for pointing out to me the importance of Wilhelm Roscher in the development of German historical and institutional thought. The development of Christian social economic thinking through the late 1800s and 1900s is an area that contains a huge degree of historical relevance in terms of debates about the role of state intervention. The theological context is obviously not present in modern BE debates but that does not reduce the significance of these works. The development of various forms of European social economic thinking throughout the 20th century sets a vital historical context for understanding how many European countries established their social democracies and in the works that formed the intellectual backdrop of this there are many debates about the freedom and dignity of the individual set against the wider public welfare and profit and innovation in a capitalist system.

Edgeworth's Mathematical Psychics is a classic work and is eerily relevant to modern debates about decision-making despite being published in 1881. David Colander's excellent JEP article on Edgeworth and Fisher is well worth reading.

Lewin "Economics and Psychology: Lessons for Our Own Day From the Early Twentieth Century" documents the interaction between the development of neo-classical marginalist economics and the development of psychology as a separate discipline. See also Bruni and Sugden's 2007 EJ article argues for the historical importance of Pareto in severing the link between economics and psychology.

This article explores parallels between the debate prompted by Pareto's reformulation of choice theory at the beginning of the twentieth century and current controversies about the status of behavioural economics. Before Pareto's reformulation, neoclassical economics was based on theoretical and experimental psychology, as behavioural economics now is. Current ‘discovered preference’ defences of rational-choice theory echo arguments made by Pareto. Both treat economics as a separate science of rational choice, independent of psychology. Both confront two fundamental problems: to find a defensible definition of the domain of economics, and to justify the assumption that preferences are consistent and stable.

Irving Fisher "Is "Utility" the Most Suitable Term for the Concept It is Used to Denote?" gives a strong sense of the early unease at the notion of utility that emerged from the marginalist period.

Daniel Read's "Experienced Utility from Jeremy Bentham to Daniel Kahneman" provides a detailed account of the attempt to measure utility directly over the centuries. Ulrich Witt also reviews the history of utility distinguishing between sensory utilitarianism that seeks to measure utility directly and the more axiomatic form that dominated in the 20th century. 

William James' The Principles of Psychology is often regarded as the first psychology textbook. Again, time-permitting, a later post on contemporaries of James such as Wundt and Fechner would yield a number of relevant works.

Freud's distrust of empirical analysis puts him at odds with a lot of modern methodological thinking. But his books are surely worth reading for any thinking person and the concepts he grappled with have obvious resonance with behavioural economics models of human behaviour.

Frank H, Knight's classic "Risk, Uncertainty and Profit" provides ideas on the role of uncertainty in economics that continue to be highly relevant.

Keynes' General Theory set out many of the themes in what is now beginning to be called behavioural macro.

Karl Polanyi's "The Great Transformation" is a key work across several interdisciplinary disciplines in Economics. It contains a vast range of insights into the development of market societies and the psychological, cultural, and other aspects of market behaviour.

The work of Maurice Allais was written exclusively in French and not widely translated making it all the more remarkable he was awarded the Nobel Prize in 1988. A study of Allais would require a lot of time, patience and linguistic ability but he is clearly an important figure in the history of economic thought relevant to behavioural economics. Paul Samuelson famously stated that “Had Allais's earliest writings been in English, a generation of economic theory would have taken a different course.”

As much a warning about excess as anything else, Watson (1913) "Psychology as the Behaviorist Views it" is the classic statement of the behaviourist view of psychology.

Frederick et al's 2002 summary of the literature on time discounting provides an exceptionally useful historical background to the development of ideas in this area from the 1800s onwards.

A VAT (value added tax) with no other tax — no income, corporate, estate, etc. etc. etc. — is pretty much the economists’ ideal. But how do you make it progressive? A bright — or perhaps lunatic— idea occurred to me.

A progressive VAT

Everyone pays the maximum VAT rate — 40% say, equal to the maximum marginal federal income tax rate. Then, as you spend money over the year, you turn in your receipts — figuratively, we’re going to do al this electronically in a second. So, for the first (say) $10,000 of purchases in each year, you get a refund of all VAT taxes paid. For the next $20,000 of purchases, you get $30 out of every $40 tax payments back, so you pay a 10% rate. And so on. Finally, after (say) $400,000 you don’t get anything back, so you pay the 40% maximum rate.

As you see, I give people an incentive to declare all their consumption.  That incentive completes one of the main advantages of a VAT over an income or sales tax. In a VAT, each business in the production chain pays the VAT on its inputs, and charges the VAT on its sales. It then deducts the VAT payments on its inputs against the VAT it has to pay on its sales. That gives the business a strong incentive to collect the VAT on sales, and for its business customers to demand proof the VAT was paid so they in turn can deduct VAT payments against their VAT collections. Now people will also demand “receipts,” proof of tax payment.

Clearly this works only if everything is electronic. I would not inflict expense reimbursement drudgery on the American taxpayer. But that largely is the case. We have a sales tax reporting mechanism, so adding or substituting VAT tax reporting is not that hard.


The big change is that each transaction must report the buyer as well as the seller. As a civil libertarian, this initially struck me as a deal killer. We have already lost far to much privacy and anonymity of transactions. But on second thought perhaps it is not that bad. We already report to Leviathan every source of our income, and under e-verify and other immigration controls we have to ask Leviathan for permission to work. Just how much worse is it to report every purchase too? Especially since, once this progressive VAT replaces the income tax, we no longer have to report sources of income. Furthermore, only the amount of the tax payment needs to be reported, not the nature of the purchase, or even who the seller was.

For those of us who already use debit and credit cards for transactions, this would be easy — the card company can simply forward to the IRS that you paid x much VAT. It does not have to report where you paid it or what you bought. It can separately report that the store paid its tax, without saying who to. For those who don’t use electronic transactions, well, it’s high time they did.  If India can set up debit cards and cell phone payments for all its citizens, the US can do so as well. That would make social security, disability, and all other government payments much safer and more secure, and undercut the fees charged by check-cashing businesses in poor neighborhoods. If you pay with cash, swipe your card to record and report the transaction and tax paid. Your incentive to do so is then you get the refund.

I’m sure creative blog readers can do better. Stored value cards or blockchain technology might securely and report taxes paid even better.

It could even be instantaneous. The store pays the VAT electronically, and the Treasury credits your debit-card account with the VAT refund immediately.

Obviously, also, large payments like houses and cars will carry forward over several years, so as not to bump people in to higher expenditure categories.

Of course, reporting individual’s purchases is only required from the desire to make a VAT directly progressive. If you’d be happy with a flat VAT and then achieving redistribution by sending people checks, we don’t have to report anything. Everyone pays (say) 20% VAT, and the government sends checks, on budget, to worthy people.

But I’ll assume that this isn’t enough, and you want to tax the rich more than this allows, so we also have to make the VAT progressive. That goal requires keeping track somehow of how much you consume.

Standard approach

The standard approach to a progressive consumption tax works through the income tax system. Collect information on all income as now, exempt capital income from taxation (dividends and capital gains) then allow people to deduct savings. Roughly, remove all the limits on 401(k) and similar schemes.

This approach is much less clean. People have an incentive to hide income. Furthermore they have an incentive to make what is really taxable labor income look like capital income. Any professional can incorporate and pay him or herself outsize “dividends” on the investment rather than “wages.”

People also have an incentive to make what is really consumption look like business investment. That yacht is really somehow a corporate investment. Well, incorporate yourself, offer just enough paid cruises to keep the IRS happy, and it is. In my world, we pay VAT on investment goods just as we do on consumption goods. And charge VAT on the cruises. If the VAT charged does not cover the VAT paid, it’s consumption and it’s taxed.  And many other gnarly problems.

Similarly, my first idea was to track consumption electronically, as above, and then force high-consumers to pay a higher rate at the end of the year. But then they have an incentive to try to hide consumption, which might be easier than hiding income. By paying taxes and filing for refunds, everyone has an incentive to declare everything.

The European system is even less clean; A flat VAT (20% or so), also a payroll tax (40% or so) and also income and estate taxes on top of that (50% or so). They achieve progressivity with the latter, but suffer all the consequences of an income tax.

It's also important not to let the VAT get screwed up by responding to political pressure for different (lower) rates on different goods, to try to transfer income indirectly or to subsidize pet industries.

Why is a consumption tax so important? 

Fundamentally there is no reason to tax or to redistribute high incomes. If you want redistribution, you want to redistribute consumption. If you have a high income but leave it all invested in a business and live like a pauper, good for you.  The wealth is out there doing good.

Conversely, there is no reason to exempt high consumption that somehow comes from low income. President Trump, according to media reports, managed to get the income tax deductions associated with billions of dollars of his investor’s losses, perfectly legally, and hasn’t paid much tax since. Under a progressive VAT, all those houses and helicopters would be taxed.  

The original sin of the US tax code was to tax income not consumption. Once we tax income, we have to tax corporations, since otherwise individuals incorporate to hide their income. (In case you’re late to the party, The right corporate tax is zero. Every cent of corporate tax comes form higher prices, lower wages, or lower returns to shareholders. Since shareholders can most easily avoid it, my bet is all higher prices. If you understand that you pay higher prices because of sales taxes, then it immediately follows that you pay higher prices because of corporate taxes.)

With a consumption tax in place of an income tax, corporate taxes can disappear; the whole issue of non-profits dissappears — goodby Lois Lerner, goodbye shady “charity” tax dodges — there is no need for the vast confusing array of 401(k), 526(b), IRA, 1031 exchanges (rules delaying capital gains realizations) etc. We don’t need health savings accounts — all savings accounts are tax free!  This vast simplification appeals to me most of all.

There is also the standard economic argument for consumption taxes. If you tax investment returns, people just save less, the capital stock falls, and the rate of return is the same. People can avoid capital gains in particular by just not selling stock.

An income tax made sense in 1914, when it was a small tax aimed only at high incomes, and when incomes were much easier to measure than consumption. But that is no longer the case.

It is possible. Imagine the huge bonfire of hundreds of thousands of pages of the tax code, replaced by one simple VAT -- essentially a sales tax. Now the obstacle of progressivity is gone too.

Starve the beast? 

The main argument I hear against a VAT is that it is too efficient. It can raise so much revenue that government will expand. Starve the beast, these authors say.

I think  this is wrong.

First, it is not a great success.  Government spending seems hardly constrained in the US by lack of revenue, or the specter of a debt crisis.

Second, think just how little faith this reveals in democracy. Shhh, economists, don’t advocate a much more efficient tax system, because a democracy will always operate at the top of the short-run Laffer curve given its tax structure. If democracy is so incapable of self-governance, we might as well hand the keys to western civilization to the Chinese communist party, as we are doomed.

Third, remember that US government overall (federal state and local) spends about 40% of GDP already. If you add in all the hidden spending — tax expenditures, deductions such as mortgage interest, health insurance, charitable, energy deductions, and mandates on business — we’re probably at least a European 50%. I’m proposing a VAT and nothing else, and let’s put all the cross-subsidies and mandates on budget where we can see them. If we make it progressive, the highest rates hit levels that would please Piketty. I’m not sure there is a lot more to squeeze out of this!

So, I am coming to the opposite view. Not: If you want to cut spending, suffer a vastly complex, growth-killing, disincentive-riddled tax system, which produces little revenue at maximal distortion, so as to try to scare the spenders away with a debt crisis. Yes: if you want to cut taxes, cut spending. Once surpluses pile up, they’ll cut taxes.

But let us admit that economists on both sides of this debate are playing amateur (very amateur) political science. We should stick to economics — The VAT is the most efficient tax system, and here is a way to make it progressive too, if you so wish.

Someone must have thought of this already? If so, let me know who! Or there is a fatal flaw I haven't thought of?

Updates: 

Bob Hall reminds me that the Hall Rabushka tax achieves much the same objective, though by a different mechanism.

Kevin Williamson has an excellent essay in National Review explaining some of the many reasons the corporate tax should be abolished.

Nina Olson has a nice WSJ oped on the complexity of the US tax code. The code includes

six “family status” provisions ..filing status, personal and dependency exemptions, the child tax credit, the earned-income tax credit, the child- and dependent-care credit, and the separated spouse rule. …

“at least 12 savings for education incentives—far too many for most parents and students to make an informed choice.”

There are now at least 15..incentives that encourage savings for retirement (IRA, roth, 401k, etc.) 

Of course that’s just the beginning, and even just the beginning of personal income tax complexity, let alone the corporate tax. Oh, and

In 1955, there were 14 civil penalties in the tax code. Today, there are more than 170..

Ms. Olson has been the “national taxpayer advocate” since 2001. But even she has to hedge with “at least” and “more than” — apparently even she doesn't really know just how many there are!

See below for two research posts working with colleagues at UCD:

(i) Vacancy for Research Scientist in UCD; we are seeking a researcher to contribute to an Irish Research Council (Research for Policy & Society) funded project about understanding well-owners perceptions and awareness of flooding, and informing policy to increase preparedness to reduce the risks of infectious disease outbreaks. Masters or PhD with training/experience in qualitative and/or quantitative research methods required. Salary will reflect qualification and experience. Closing date for application May 3rd. Email eoin.oneill@ucd.ie for further information. Check out the postion at http://www.ucd.ie/hr/jobvacancies/ Job Ref : 009243

Luigi Zingales inaugurated a series of essays in Il Sole 24 Ore, an Italian newspaper, on whether Italy should stay in or get out of the Euro, and graciously asked me to contribute. My view, here in English, here in Italian.

To be clear, I kept to Luigi's terms of the debate. This piece is only about whether Italy is better off in the long run, with a common currency. Whether it gets anything out of an exit, a devaluation, a default now is for another day. And this is just about currency, not about leaving the EU, not about debt or austerity, not about whether europe needs a fiscal union, or the rest of it. (Some subsequent correspondence verifies the wisdom, but also the difficulty, of talking about one thing at a time.)

Return to the Lira? A long-run view (Not very good English title)
The euro isn't perfect, but it isn't bad. (Much better Italian title)

Should Italy have her own currency, and run her own monetary policy? For today, let's focus on the long-run question, leaving out for now the transition and any immediate benefits and costs. When contemplating a divorce, it is wise to focus on what life will be like when everything is settled, not just who will have to wash today's stack of dirty dishes.

Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work. In turn, productivity comes from innovation, new companies, new ways doing business, and new products. Like Uber, consumers benefit and existing producers are disrupted. Improvements in long-run growth come only from structural reform, not monetary machination. Money is like oil in a car. Bad monetary policy, like too little oil, can drag an economy down. But after a point more oil will not help you to go faster — you need a bigger engine.


In the short run, monetary policy can also “stimulate” an economy. It's like an afternoon espresso — good when you're feeling a little sluggish, but not wise to drink all the time, and in the end no substitute for diet and exercise. And that is the major advantage offered for an independent currency and monetary policy — the possibility that a wise monetary authority can offset bad shocks with occasional bursts of devaluation and inflation.

But “wise” is a major caution. When the central bank lowers interest rates, inflates, or devalues, that helps exporters, but hurts importers; it helps government finances, but lowers the real amount the government pays its workers, pensioners, and bond-holders; it helps borrowers but hurts those who lent money to the government, homes and businesses.

Once hurt, they wise up. Anticipating the next devaluation and inflation, workers and pensioners demand indexed wages and pensions. Bond investors demand higher interest rates.

So having your own currency really only works for a government whose finances are in sound shape, and whose public institutions are strong enough to resist the constant clamor for one more inflation. Just this once. Again and again.

Staying in the euro thus represents an important pre-commitment. By forswearing the ability to easily devalue and inflate ex-post, Italy benefits from much better credit and investment ex-ante. It is up to her to use this credit wisely, as Greece so notably did not.

Devaluing and inflating is said to work because prices and wages are “sticky,” and do not quickly adapt to inflation. Thus people are fooled into working harder than they would otherwise, or into accepting wage and price declines they would refuse if they could see them directly. But, if used often, they too will wake up and stickiness vanishes.

Furthermore, devaluation and inflation to exploit such stickiness can address an overall level of wages or prices that is too high, but it cannot address an industry or a region that is too high while another is too low. And variation across industries and regions is larger than variation across countries. If stickiness is the problem, it would be much better to remove all the policies that encourage sticky prices and wages in the first place. For Italy in particular, the arguments for one currency are really arguments for two currencies, one for the North and one for the South.

If that sounds unappealing, perhaps one currency is unappealing too.

Italy will face tight limits on what it can accomplish with wise monetary policy. Let us hope that having its own currency means Italy still somehow remains a member of the European Union, or at least its somewhat free-trade and free-investment area, like Denmark, Norway, or pre-Brexit UK. Let us hope that Italians can still buy and sell goods freely across Europe, they can conduct their business in euro or lira, own bank accounts in both currencies, freely buy and sell securities, work in Europe and hire whom they please.

Do not take all of this for granted. The first thing many governments do, faced with weak currencies and government debt problems, or noticing their monetary stimulus efforts have little effect, is to force their citizens to use that weak currency, to ban foreign bank accounts, to limit citizens' rights to buy and sell euros or to borrow or invest abroad. They limit foreign banks, in order to prop up domestic banks who must hold domestic currency and debt. They limit the interest citizens get at banks, and allocate bank credit.

All this passes under bureaucratic bromides like “capital controls.” Economists call it “financial repression,” which gives a better sense of its effect. This is the kind of monetary policy that, like removing oil from a car, really can slow it down. And it is not clear that Italy even can leave the euro without leaving the EU.

If Italy remains open, as she must to grow, monetary policy will always be constrained by the exchange rate and competition from the euro. Too much loosening will cut the exchange rate too much, and vice versa. Wild exchange rate fluctuations are bad for business and investment all around. Italians will just use euros instead, undermining the value of a domestic currency, leading to capital controls. Even Iceland is now thinking it should peg to the euro. Switzerland and to a lesser extent Denmark are fighting hard to keep their currencies from rising.

So will Italy be better off in the long-run, back with her old sweetheart, the Lira? A well-managed currency within an economy open to trade, capital, and people, can have some benefits. The experience of pre-Brexit UK, Denmark, Switzerland, Norway, or Sweden offers small advantages, some challenges, and no particular disasters so far. The experience of pre-euro Italy is less encouraging, that of pre-euro Greece less so, and that of many small countries challenged by debt and growth less so still. Round after round of inflation and devaluation did not produce prosperity, and capital and exchange controls hurt growth substantially.

In the end, no monetary machination can substitute for a dynamic real economy. The Euro, while not perfect, is pretty good, and it offers an important pre-commitment against bad policy. The dangers and temptations of a Lira do not, in my view, compensate for the loss of an occasional afternoon espresso of stimulus.

These are comments I gave on "Inflating away the public debt? An empirical assessment" by Jens Hilscher, Alon Aviv, and Ricardo Reis at the Becker-Friedman Institute Government Debt: Constraints and Choices conference, April 22 2017, along with generic comments on the conference in general. This post contains mathjax equations.

Long Term Debt

Consider the government debt valuation equation, which states that the real value of nominal government debt equals the present value of primary surpluses.

My first equation expresses this idea with one-period debt, discounted either by marginal utility or by the ex-post return on government debt.
$$\frac{B_{t-1}}{P_t} = E_t \sum_{j=0}^\infty \beta^j \frac{u'(c_{t+j})}{u'(c_t)} s_{t+j} = E_t \sum_{j=0}^\infty \frac{1}{R_{t,t+j}} s_{t+j}$$
(\( P \) is the price level, \( B \) is the face value of nominal debt coming due at \( t \) , \( s \) are real primary surpluses, \( R \) is the real ex-post return on government debt.)

This paper's question is, to what extent can inflation on the left reduce the value of the debt, and hence needed fiscal surpluses on the right. The answer is, not much.


The first equation seems to offer some hope. If you change \(P_t\) by, say 30%, then you devalue nominal debt B by 30%, and you can lower the steady state surpluses needed to pay off the debt by 30%.

The trouble is, this only works for an unexpected 30% price level jump. 3% a year for 10 years won't do it. If people expect inflation starting next year the governments gets precisely nothing out of it. Nominal interest rates rise, and short term debt completely avoids devaluation by expected inflation.

Now, this calculation (and those in the paper) makes a crucial assumption here: that nominal interest rates rise one for one with expected inflation. A possible reading of the last 8 years is that the Fed lowered both nominal and real interest rates. If so, then a rise in expected inflation might similarly leave nominal rates behind, and inflation could erode even short-term debts. Debt can run away from inflation, but if it chooses not to, it loses.

Exchange rate jumps are easier to engineer, and as the paper documents a lot of US debt is held abroad. So there is a bit more of a chance that devaluation can work, which would be an interesting extension.
$$\frac{\sum_{j=0}^\infty Q^{(j)}_{t} B^{(j)}_{t-1} }{P_t} = ... = E_t \sum_{j=0}^\infty \frac{1}{R_{t,t+j}} s_{t+j} $$
My second equation expresses the government debt valuation equation with long term debt. (\( Q^{(j)}\) is the nominal bond price of maturity \( j \) zero-coupon debt, and \( B^{(j)}\) is the outstanding quantity.)

Long term debt has several useful properties for government finance. With one-period debt, shocks to the present value of surpluses s are reflected immediately in the price level \( P_t\). With long-term debt, nominal bond prices \( Q \) can decline instead and absorb some or all of the fiscal shock. Declining bond prices reflect future price level rises, so long term debt helps really by spreading the inflationary impact of the fiscal shock across time. Similarly, long-term debt buffers the fiscal impact of interest-rate shocks, as it does for a household choosing a fixed vs floating rate mortgage. Interest rate increases do not affect debt service until the debt rolls over.

Long-term debt helps for this paper's question as well.

The presence of outstanding long-term debt allows the government to devalue debt claims via expected and therefore slow-moving inflation. Higher expected inflation lowers bond prices \( Q \) , resulting in lower future surpluses, even with no change in the current price level \( P_t\).


Figure 1 gives a very simple example. At time 1, debt of four maturities is outstanding. The government will pay off this debt with four surpluses. The surplus required at each date is then the real value of the arriving coupon. If at time 1 the government raises the price level at times 2, 3, 4, then it will have to run lower surpluses at those dates to pay off the debt. (In general the dynamics are more complex as the government will roll over some of this debt, but the point remains true.)

Cumulative distribution of Federal Debt n 2012. Each point plots the total zero-coupon debt coming due after that date. Source: Hilscher, Aviv, and Reis.

Alas, the US does not issue much long-term debt. Figure 2 is a plot of the cumulative distribution of debt -- each point is the amount of debt of that or greater maturity -- using the author's data. About half the debt is less than one year maturity -- the US rolls over half its debt every year. Two thirds of the debt is less than three years maturity. (This figure is the cumulative analogue of the paper's figure 1. I added back currency and reserves. The paper subtracted Fed holdings of Treasuries but did not add back the corresponding liabilities. This change only affects the leftmost point.)

Thus, for example, an announced 30% inflation in year 3 only results in a 10% reduction in the value of the debt. The slower, smaller, and longer-lasting inflations considered in the paper have correspondingly smaller effects.

That's the basic message of the paper. Inflation trundling along with its current variance is quite unlikely to do anything like that. And conceivable deliberate inflation, even if our Fed knew how to achieve it, would have limited effects.

The budget-busters

The paper announces its goal as,

" ... to quantify the likelihood of inflation significantly eroding the real value of U.S. debt."
I want to generalize the quest, and ask "To what extent can greater inflation significantly improve the US fiscal situation?" And I want to ask the converse, "To what extent is the US fiscal situation likely to result in inflation?" Both questions allow me to comment a bit on the larger issues raised in this conference as well.

A government is tempted to default via inflation if debt service requires onerous taxation. At a steady state, surpluses must be r-g times the debt/GDP ratio.
$$b_t = \frac{ B_{t-1} }{P_t} = E_t \sum_{j=0}^\infty \frac{1}{R^j} s_{t+j} $$
$$\frac{b}{Y} = \frac{s/Y}{r-g} \; \; \; \rightarrow \; \; \; \frac{s}{Y} = (r-g)\frac{b}{Y} $$
But r minus g is perilously close to zero! So current debt at current interest rates requires at most something like half to one percent of GDP debt service, or $75-$150 billion dollars a year. Table 1 adds up components of primary surpluses and deficits.

Table 1. Components of primary surpluses.

	% of GDP	2017 $
Debt service		$95b - $190b
CBO deficits	3% (2017) - 5% (2027)	$550b - $950b
Kotlikoff fiscal gap	10.5%	$2,000b

(Throughout I ignore the possibility that r-g is negative, that markets will support arbitrarily large debt/GDP ratios. If so, government debt is a literal money tree, and there is no problem to start with. The eventual end of the Earth when the sun becomes a red giant is enough to put a stop to it. Moreover, I am increasingly convinced by the Chad Jones revision of growth theory that economic growth must eventually be linear, not geometric, so the right value of g is zero in the long run.)

The CBO reports this year's deficit at $550 billion or 3% of GDP, and rapidly rising to $1.4 trillion or 5% of GDP by 2027. That's already a lot bigger than debt service. (CBO forecasts cite appalling debt service amounts, but those are largely debt service on debts still to be incurred as primary deficits spiral. You can't inflate away debts you haven't yet incurred.)

The US' big fiscal challenge is looming primary deficits. And those fundamentally come from social security, medicare, medicaid, pensions, and voluminous explicit or implicit credit guarantees.

One way to think of the long-run entitlements problem is as "debts," that should be included on the left hand side. Larry Kotlikoff computes a "fiscal gap" of $210 trillion, dwarfing the $13 trillion or so of publicly held Federal debt.

(The paper acknowledges but ignores these issues, for the reason that they are hard to measure.

"Unfunded nominal liabilities of the government like Social Security could be included in \( B_t^j \), and the real assets (and real liabilities) of the government could be included in \( K_t^j\). Theoretically, they pose no problem. In practice, measuring any of these precisely, or taking into account their lower liquidity, is a challenge that goes beyond this paper, so we will leave them out."

But the debts are large, so cast a big shadow on any calculation that ignores them.)

These numbers are imponderably huge, and sensitive to interest rate assumptions. I think it's easier to digest them by translating into flows. Kotlikoff's fiscal gap is 10.5% of his present value of GDP. So, to fix it, either Federal taxes must rise by 10.5 percentage points of GDP, from roughly 20% to roughly 30%, or spending must be cut by 10.5 percentage points of GDP. Permanently. Now.

(By the way, if you're feeling superior and taking comfort that Europe will go first off the cliff, Kotlikoff disagrees. Europe's debts are larger, but their social programs are better funded, so their fiscal gaps are much lower than ours. The winner, it turns out, is Italy with a negative fiscal gap. Answering the obvious question, Kotlikoff offers

"What explains Italy's negative fiscal gap? The answer is tight projected control of government- paid health expenditures plus two major pension reforms that have reduced future pension benefits by close to 40 percent."

Don't get sick or old in Italy, but perhaps buying their bonds is not such a bad idea.)

Viewed as flow or present value, it's clear that today's debt or debt service, at current real interest rates, is just not a first-order issue for confronting US fiscal problems. They may be hard to measure, but they are the elephant in the room.

We can, and should, still ask the question whether inflation would help or hurt. To first order, the answer seems to be not much. Social security is explicitly indexed, and health care costs are real. Many union contracts have cost of living clauses. Perhaps the elephant is not so inflation-sensitive.

To second order, inflation may matter. "Inflation is the dean's best friend," a dean once told me. Non-indexed government wages may be slow to adjust. Medicare and medicaid reimbursement rates are sticky, with so little price discovery and competition left in health care, so real government health expenses may lag inflation. Many government pensions remain defined benefit. And inflation remains the friend of the tax code, including taxing inflationary capital gains, devaluing unused depreciation allowances and nominal loss carry-forwards.

Yes, calculating the inflation sensitivity of entitlement "debts" is hard. But I suspect it does matter at least as much as inflating away the current debt, so if the question is worth asking, this answer is worth calculating. I also suspect the answer will still be that you're not going to get $2 trillion of annual surpluses or Kotlikoff's gazillions of present value out of inflation.

(The paper acknowledges the fact,

"Higher inflation may not only lower the real payments on the outstanding nominal debt, but also change primary fiscal surpluses."

but, reasonably given its scope, does not address it. This is is, appropriately, a suggestion for future research. )

Anytime debt and inflation comes up, so does seignorage. One way to think about it is that seignorage too provides a way for higher inflation to help current surpluses, rather than just be devaluing debt. Seignorage, rather than debt devaluation is the main mechanism in Sargent and Wallace's models of hyperinflations.

Currency is now $1.4 trillion. Reserves are trivial when they do not pay market interest. 10% inflation would generate $140 billion of surplus. However, currency demand falls when inflation rises. Currency, now about 7.5% of GDP, was less than 4% of GDP in 1980, and that was before electronic payments. So seignorage is probably capped for the US at something like $50 billion per year, and not really going to make a dent. But on the other hand, seignorage is comparable to the size of the inflationary effects in the paper, so it probably makes sense to include it.

(The paper says, "In companion work (Hilscher, Raviv and Reis, 2014), we measure one of these effects through the seignorage revenues that higher inflation generates.")

How will it work out? Or not? How might inflation happen?

$$b_t = E_t \sum_{j=0}^\infty \frac{1}{R^j} (\tau Y_{t+j} - G_{t+j}) $$
$${b} +PV(G) = \frac{\tau Y}{r-g} $$
So how will our fiscal problems work out? Remember this equation holds, ex ante and ex post. If current projections don't add up, something is going to change in those projections, and those projections do not correspond to expectations driving the market value of debt. So our question is, how does it hold ex ante -- why do agents value government debt so highly -- and how is it going to hold ex post?

Most obviously, there could be fairly massive cuts in entitlement programs, \( G \) relative to current projections. These are not really "debts." Cutting them does not entail formal default. Beneficiaries cannot sue, grab assets, and most of all cannot run or refuse a roll-over. All they can do is vote. I suspect that markets are betting on eventual entitlement reform.

The equation can hold ex-post from massive negative returns, i.e. an eventual default or large inflation, after a large amount of additional debt has been issued. Naturally, that must be unexpected.
More growth is the most sunny possibility. If r-g is 2 minus 1, all it takes is one percentage point more sustained growth g to double the value of tax receipts. In my view, that is not an outlandish hope for what tax and regulatory reform could do, along with the fruits of today's software and biotech. This view may also help to account for the market's high valuation of US debt.

(For growth to solve the fiscal problem, we must assume that the government does not choose to raise health and pension entitlement spending with higher GDP. But that would be a choice -- the entitlements are not GDP indexed.)

What about raising taxes? Absent other cures, we are likely to get much higher taxes eventually, but I think they are much less likely to work. With our current preferences for progressive taxation, and on top of state and local government taxes (and their own problems), ten percentage point higher federal taxes are going to put many current economists' dreams, and Art Laffer's fears, of confiscatory high-income and wealth taxation to the test.
$$\frac{d}{d \log \tau}\left(\frac{ Y}{r-g}\right) = 1+ \frac{d\log Y}{d \log \tau} +\frac{1}{r-g}\frac{d g}{d\log\tau} $$
To think about this issue, I wrote down here the elasticity of the present value of tax revenue with respect to tax rate. The second term is the conventional static Laffer term, which most people think is small. The important point is the third term, which I call the present-value Laffer term. Because r-g is so small, 0.01 or 0.02, it takes only a tiny growth effect effect of taxes to destroy the present value of tax receipts. If Laffer effects take time and affect growth-- if they affect occupational choice, entrepreneurship, long-term R&D investment, business formation and so on -- they can destroy the present value of tax revenue, even though we may never see declines in the level of income. " (Considering labor effort, a higher flat tax rate has equal income and substitution effects, so conventional wisdom assigns a small labor-effort elasticity. One can argue -- more progressive taxes have substitution but not income effects -- and there are many other channels for static Laffer elasticities. But my point is to focus on the third term and dynamic Laffer effects, so I ignore this one here.

As in all my calculations, we do not have to have a "growth effect" vs. "level effect" argument. Growth that lasts 20 years due to a level effect with transition is enough; permanent growth just gives very simple formulas.)

Finally, let's ask how the equation might fall apart -- i.e. result in an unexpected deflation or default. Let's separate out tax receipts and the troublesome spending driven by entitlements,
$$b_t = E_t \sum_{j=0}^\infty \frac{1}{R^j} (\tau Y_{t+j} - G_{t+j}) $$
or in present value terms, with Kotlikoffian "debt" on the left hand side,
$${b} +PV(G) = \frac{\tau Y}{r-g}. $$
As a little more \( g \) would help a lot, a little less \( g \) would hurt a lot. Each point of stagnation makes our governments promises more and more unsustainable.

I think our most immediate danger is a rise in interest rates. If the real rates r charged to our government rise, say, to 5%, then the service on a 100% debt/GDP ratio rises to 5% of GDP, or $1 Trillion dollars. Now, debt service really does matter, and our outstanding stock of debt really does pose a surplus problem.

There are two mechanisms that might raise interest rates. "Not so bad" interest rate rises come as a natural consequence of growth. Higher per capita growth times the intertemporal substitution elasticity equals higher interest rate. If the elasticity is one, the interest rate rise "just" offsets the benefits of higher growth.

Conversely, low real interest rates can buffer the impact of lower growth. \(\gamma\) above one and \( r \) thus falling more than \( g \) may be a reason why our current slow growth comes with rising values of government debt.

"Really bad" interest rate rises come without growth, from a rising credit spread -- the Greek scenario. If markets decide that the entitlements are not going to be reformed, cannot be taxed away or grown out of, they will start to charge higher rates. Higher rates explode debt service, make market more nervous, and so forth until the inevitable inflation or default hits. In present value terms, higher \( r \) can quickly make the present values on the right implode. This sort of roll-over risk, interest rate risk, or run has been the subject of at least half the papers in this conference.

Here, I find the most important implication of this paper's calculations. The paper shows that the US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. The paper shows that a large slow inflation results in a small change in the present value of surpluses. It follows, inexorably, that if a small change in the in the present value of surpluses has to be met by inflationary devaluation, that inflation must be large, and sharp. If \( x \) is small, \(1/ x \) is large.

We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our "reserve currency" status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world. That, I think, is the big takeaway from this paper -- and this conference.