Economist Channel

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

A few snippets:

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

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

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

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

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

This is the main theme:

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

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

Retroactive decisions are common,..

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

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

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

Always be optimistic though:

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

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

John Campbell's text, "Financial Decisions and Markets" is out from Princeton University Press. With some mild chagrin, I must say it's a splendid book. (Chagrin, of course, because it's an obvious major competitor to my own effort in Asset Pricing.)

It is spare, concise, and clearly written. How can I say that of a 450 page book, with wide text and tiny margins? Well, it's the concise version of the Encyclopedia Britannica, breathtakingly comprehensive and up to date in its coverage of important research topics.

The first part is a whirlwind tour of asset pricing theory. Here, John adopts the traditional organization -- expected utility, static portfolio choice, static CAPM and APT as equilibrium relations where supply meets demand, and finally we meet the discount factor and consumption-based pricing. I chose to go the other way around, and start with the basic asset pricing equation \(p_t u'(c_t) = E_t [\beta u'(c_{t+1}) x_{t+1} ]\), following Bob Lucas' insight that asset pricing is the same as in an endowment economy, and filling out the CAPM and APT and so forth as special cases. I never even got to portfolio theory -- it's in a draft chapter for the long-delayed next version. I still think that's the right organization, but most people don't want to teach it that way. John's more conventional organization, combined with clarity and concision, may be more what you want.

Even here, John's empirical taste and contributions rings through Any textbook is in many ways a summary of its authors' research journey, and John's journey has gone far and wide. You see a preview of the style on the 6th page of chapter 2 (p. 28) where you meet approximations for log returns, and the growth-optimal portfolio on the next page. On calculating minimum-variance portfolios, on p. 37, you get  graph of time-varying return correlations from Campbell Lettau Milkier and Xu (2001), a provocative fact usually ignored. After efficiently presenting the classic CAPM, we get (p. 51) an insightful application to Harvard's endowment, highlighting the difficulties of using these oft-repeated portfolio and pricing theories in practice.
This book is  infused with up to the minute empirical work and practical application even in the most basic theory sections. Starting on p. 61 John moves swiftly from the CAPM theory to empirical evidence, and implicitly, methodology. The next 16 pages cover the standard regression test approaches, swiftly show the evidence for the value and size cross sections, a nice treatment of momentum, a good yet economical coverage of the major anomalies and then a quick and digestible survey of reactions such as conditional capm, multifactor models, and behavioral finance. The coverage is comprehensive and up to date without being overwhelming.

Then the book really gets going. You would expect Chapter 5 on present value models to be excellent, and it is, somehow while also being brief. It covers not just the basics such as Campbell Shiller present value model and VARs, but includes a useful section on "Interpreting US stock market history" to bring equations alive, an excellent section on the econometrics of return forecasting, drifting steady state models, present value models in the cross section and more. Somehow in 40 pages John has distilled his own major research contributions, and several hundred papers of a still active literature, yet brought you up to date. My coverage focused only on the simplest idea, and wasn't one tenth this complete a summary of the current literature.

Chapter 6 on consumption based asset pricing is likewise elegant and comprehensive. John jumps right in to data with the equity premium, riskfree rate, and volatility puzzles (p. 164). Then he quickly outlines the huge literature of responses to the puzzles (p. 167) again in short digestible paragraphs. The big ones, time varying disasters, Epstein-Zin, long-run risk, ambiguity aversion and (nearly last but not least) habit formation and durable goods each get a few well-chosen pages, each self contained with derivations (a derivation of the Epstin-Zin SDF is not fun), but not windy. Unusually, John also includes an elegant chapter 7 on production-based asset pricing and general equilibrium. I think this approach is relatively unexplored and promising -- I'm glad to infer John agrees. In both areas, my latest survey in Macro-Finance is not nearly as economical. John spryly gets to the point.

It wold not be a John Campbell book without a chapter on fixed income, and this one does not disappoint. Affine models, empirical work on the expectations hypothesis, a strong emphasis on the link between macroeconomics and term structure - absent in most treatments -- and linking interest rates and exchange rates are strong points.

Here though, you see one limitation of the book, in scope at least. Everything, including fixed income, is done in discrete time. This fact certainly makes it more accessible to economists, and most of John's voluminous work has been in discrete time. But most of the ideas in asset pricing are much easier in continuous time, once one masters the elements of Ito's lemma manipulations.  Term structure models are commonly done in continuous time. In revising Asset Pricing and the online versions, I have moved entirely to continuous time rather than lognormal approximations. It's much simpler that way, and continuous time is a standard part of a finance PhD's toolkit. This otherwise comprehensive book doesn't have any option pricing in it, though Black-Scholes is a cornerstone of finance. Well, John hasn't worked on that, and his research is mostly presented in discrete time. Adding continuous time would add a lot of pages. It keeps the book quite self contained. But it does mean that a course in finance will need some other reference material for that important part.

The next three chapters reflect again many of John's wide-ranging contributions.  It is a crime that we still use static mean-variance optimization -- and by "we" I include the entire industry as well as academia -- when we know state variables are moving around all the time. John has made some great strides in trying to make intertemporal portfolio allocation and inter temporal asset pricing come alive. There is a lot left to do here, but if you want to get started Chapter 9 on inter temporal risk brings you up to date (or at least faster than trying to read all of John's papers!)

Chapter 10 on household finance is a great example of a topic that is new to the asset pricing canon. How do we understand what portfolios people actually hold?  You get a great summary of that work. It's followed by an excellent Chapter 11 on the economics of risk sharing and speculation and Chapter 12 on asymmetric information and liquidity. This too is not yet part of the textbook canon but soon will be, as these issues are central to current research.  The classic theory of finance, the joke goes, is perfectly mirrored in the market for senior faculty: Prices change, there is no volume. There is a recent explosion in understanding the mechanics of trading, and these spare chapters will send students on their way.

Like continuous time, the book also does not have a chapter on the recent explosion of models in asset pricing with financial frictions. Perhaps John just hasn't written in that area yet! But an author (me) whose finance book omitted a chapter on portfolio theory can hardly complain, and knowing John's evident mania for scholarship, it will likely be there in the revision.

In sum, this is a must-read book for any Ph. D. student in finance or financial economics, and must-have book for any serious scholar of finance. It is not organized, as I tried to do in Asset Pricing around a Big Idea, trying to move how we do research in a particular direction. That is likely an advantage. Instead, it shines in a crystal-clear, nearly encyclopedic summary of current ideas in the macroeconomics and finance literature, complete with an equally encyclopedic citation list for those wanting to go further. It is distilled like fine scotch. Barrels of fine scotch.

We host a weekly session from 930am to 1030am on Wednesday mornings to bring our researchers and students together with external stakeholders interested in this area. As well as knowledge exchange, we also hope that students will be encouraged to apply some of their material to direct policy questions. Below is current schedule. We welcome expressions of interest.



27th September: Simon Rafferty (EPA) "Behavioural Economics and Environmental Policy" and Patricia Harris (HSA): "Reducing Work Accidents in Ireland"

4th October: Clare Delargy (BIT): "Behavioural Insights Team and Public Policy".

11th October: Aine Lyng and Ronan Murphy (NCCP): "Cancer Prevention"

18th October: Cathal Fitzgerald (DETI): "Brexit and Firm Decision Making; Behavioural Economics of Innovation".

25th October: Till Weber (Nottingham): "Experimental Methods and Behavioural Economics".

1st November: Leonhard Lades (UCD and EnvEcon): "Naturalistic Monitoring of Human Preferences and Behaviour".

8th November: Michael Daly (UCD and Stirling): "Self-control and Health".

15 November: Orla Doyle (UCD): "Behavioural Economics and Early Childhood Intervention".

22nd November: Kenneth Devine (Central Bank of Ireland): "Behavioural Economics and Financial Decision Making".

29th November: Keith Walsh (Revenue): "Behavioural Economics and Tax Administration".

See below for Richard Thaler's Nobel speech. Congratulations to Prof Thaler and thanks to him for his intellectual leadership over the last decades.

Economics is mostly a quantitative discipline from the basic undergraduate principles courses to the most recent editions of the top journals. The extent to which economics students should be exposed to qualitative research methods is being debated in various ways in the UK, particularly in the context of the ESRC postgraduate training guidelines, that stipulate that all ESRC-funded postgraduates should receive training in both quantitative and qualitative research methods.

There a plethora of cultural, philosophical, and practical barriers to integrating such methodologies into mainstream economics. Many economists will object that the strength of economics has been the ability to generate testable predictions from rigorous mathematical theoretical models. Others might simply point to the expectations of students arriving onto graduate Economics programme that they will be provided with the most rigorous quantitative tools to perform modern economic analysis. Having said that, Economists are increasingly become involved in real-world field trials, where an element of qualitative research is necessary to understand the process and potentially also the mechanism of the interventions and policies being tested. Professional economists in this context will increasingly be required to understand, at least, how to intelligently consume such information.

There have also been some strong precedents for the use of qualitative research methods in Economics. Truman Bewley's famous work on why wages don't fall during a recession is one example of a well-regarded Economics work that came from structured interviews with business decision makers. More generally, the potential for qualitative research to provide greater understanding of the nature of various types of economic phenomena needs to be discussed in greater depth.

Thanks to Jeff Round (@unhealthyecon on twitter) for recommending the recently released "Qualitative Methods for Health Economics".

I will use this post to keep track of some useful references on qualitative research in Economics. Suggestions and comments welcome.

The review paper below provides a useful overview of qualitative and mixed methodological designs that might be useful in Economics.

Starr (2014). Qualitative and mixed-methods research in economics: surprising growth, promising future. Journal of Economic Surveys, Volume 28, Issue 2,  Pages 238–264.

Qualitative research in economics has traditionally been unimportant compared to quantitative work. Yet there has been a small explosion in use of quantitative approaches in the past 10–15 years, including ‘mixed-methods’ projects which usequalitative and quantitative methods in combination. This paper surveys the growing use of qualitative methods in economics and closely related fields, aiming to provide economists with a useful roadmap through major sets of qualitativemethods and how and why they are used. We review the growing body of economic research using qualitative approaches, emphasizing the gains from using qualitative- or mixed-methods over traditional ‘closed-ended’ approaches. It is argued that, although qualitative methods are often portrayed as less reliable, less accurate, less powerful and/or less credible than quantitative methods, in fact, the two sets of methods have their own strengths, and how much can be learned from one type of method or the other depends on specific issues that arise in studying the topic of interest. The central message of the paper is that well-done qualitative work can provide scientifically valuable and intellectually helpful ways of adding to the stock of economic knowledge, especially when applied to research questions for which they are well suited.

The chapter "Does Qualitative Research fit in Economics?" is also worth reading.

The fundamental reason so many markets are not free, and so dysfunctional, is that the voters of our democracy don't really want freedom. Freedom will come when we want it, when we insist on it, when the average voter sees a free market solution rather than endless controls as the answer to real world problems. The sad paradox of free markets is that free markets do not need people to understand them to work. But democracy does require voters to understand how things work.

In that vein today's internet browsing (both HT marginal revolution) brings good news and bad news.

Good news - one more piece of evidence that people from left and right are finally beginning to see the huge damage of zoning and construction restrictions, including inequality, income segregation, and perpetuation of economic status. That "progressives" now see this too is a most heartening development.


Today's data point is What Happened to the American Boomtown, in, yes, the New York Times. The piece notices the dramatic expansions that Chicago and San Francisco experienced in the 19th century, when they were economic magnets.

"Chicago in 1850 was a muddy frontier town of barely 30,000 people. Within two decades, it was 10 times that size. Within another two decades, that number had tripled. By 1910, Chicago — hog butcher for the world, headquarters of Montgomery Ward, the nerve center of the nation’s rail network — had more than two million residents. 

... It was a classic metropolitan magnet, attracting anyone in need of a job or a raise.
But ...migration patterns like the one that fed Chicago have broken down in today’s America....local economic booms no longer create boomtowns in America. 

The places that are booming in size [sunbelt, providing cheap housing] aren’t the economic boomtowns — the regions with the greatest prosperity and highest productivity. In theory, we’d expect those metros, like the Bay Area, Boston and New York, to be rapidly expanding, as people move from regions with high unemployment and meager wages to those with high salaries and strong job markets.

Source: New York Times

So what's the problem? Amazingly, the Times nails it. (Or at least its intrepid reporter Emily Badger nails, it, and the Times let her do it.)

Some people aren’t moving into wealthy regions because they’re stuck in struggling ones. They have houses they can’t sell or government benefits they don’t want to lose. But the larger problem is that they’re blocked from moving to prosperous places by the shortage and cost of housing there. And that’s a deliberate decision these wealthy regions have made in opposing more housing construction, a prerequisite to make room for more people.

Moreover, she gets not only the overall flow but its character -- lower income people move out to make room for the very high skill migrants who can pay outrageous prices to be in the high productivity clusters. This results in inequality and residential segregation.

As a result [of restrictions], housing prices have soared in the most prosperous places, making them inaccessible to lower-income workers and negating much of the allure of the higher wages there. Over this same time, ...high-skilled migrants have clustered in these areas, while low-skilled workers have been more likely to move elsewhere. 

For a Times article, the omissions are just as instructive. No mention of big housing subsidies, and  "affordable" housing mandates (which drive up the cost of market rate housing even more.) We just need to get out of the way and allow more housing.

With left and right apparently now aware of the problem, what's stopping us from fixing it? The bad news:

In the Boston suburbs, the Bay Area, Brooklyn and Washington, people who already live there have balked at new housing for people who don’t.

Several Virginia lawmakers are calling on the state to suspend tolls on Interstate 66, condemning this week’s variable tolls that hit as high as $40 as “outrageous” and “unacceptable”.

Source: Wall Street Journal

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

Update: Marginal Revolution also on bitcoin today.

This is a talk I gave for Hoover, which blog readers might enjoy. Yes, it puts together many pieces said before. This post has graphs and uses mathjax for equations, so if it isn't showing come back to the original. Also here is a pdf version which may be more readable.

Background

As background, the first graph reminds you of the current situation and recent history of monetary policy.

The federal funds rate is the interest rate that the Federal Reserve controls. The funds rate rises in economic expansions, and goes down in recessions. You can see this pattern in the last two recessions. Since about 2012, though, when following history you might have expected the funds rate to rise again, it has stayed essentially at zero. Very recently it has started to rise, but very slowly, nothing like 2005.

The black line is reserves. These are accounts that banks have at the Fed. Crucially, these bank accounts now pay interest. Starting in 2008, reserves grew dramatically from about $20 billion to $2,500 billion. The three cliffs are the three quantitative easing' episodes. Here, the Fed bought bonds and mortgage backed securities, giving banks reserves in exchange.

Inflation initially followed the same pattern as in the last recession. It fell in the recession, and bounced back again in 2012.Inflation has been slowly decreasing since. 10 year government bonds have been quietly trending down, with a bit of an extra dip during the recession.

The next graph plots US unemployment and GDP growth.

You can see we had a deeper recession, but then unemployment recovered about as it always does, or if anything a little faster. You can see the big drop in GDP during the recession. Subsequent growth has been overall too low, in my view, but it has been very steady. If anything, both growth and inflation are steadier in the era of zero interest rates than they were when the Fed was actively moving interest rates around.

These central facts motivate my heresies: Inflation, long term interest rates, growth and unemployment seem to be behaving in utterly normal ways. Yet the monetary environment of near-zero short term rates and huge QE is nothing but normal. How do we make sense of these facts?

Heresy 1: Interest rates

• Conventional Wisdom: Years of near zero interest rates and massive quantitative easing imply loose monetary policy, "extraordinary accommodation,'' and "stimulus.''
• Heresy 1: Interest rates are roughly neutral. If anything, the Fed has been (unwittingly) holding rates up since 2008.

What does a central bank look like that is holding interest rates down? Such a bank would lend money to banks at low interest rates, that banks could turn around and re-lend at higher interest rates. That's how to push rates down.

What does a central bank look like that is pushing rates up? Such a bank takes money from banks, offering to pay banks a higher interest rate than they can get elsewhere.

What's our central bank doing? In bigger format, the top panel of the next graph presents excess reserves. This is money that banks voluntarily lend to the Fed, and on which they receive interest.

Top: Reserves. Bottom: Interest on excess reserves, Fed funds rate and 1-month Treasury rate

The bottom panel is the interest that the Fed pays on excess reserves, along with the Federal Funds rate and the rate on one month treasurys, to give a sense of market rates. As you can see, the Fed pays more than banks can earn elsewhere. So, on this basis, the Fed looks like a central bank pushing rates up, if anything.

Now, as we used to say at the University of Chicago, ok for the real world, but how does that work in theory? How can it be that zero interest rates -- lower than we have seen since the great depression -- are not an unusual stimulus?

Well, it's certainly possible. Remember, the nominal interest rate equals the real interest rate plus expected inflation. If the real interest rate is, say negative 1.5%, and inflation is +1.5%, then a nominal interest rate of zero is neutral.

And, there are plenty of reasons to suspect that the "natural'' real rate has been negative for much of the period since the financial crisis. More savers than investors, low marginal product of capital in a real slow growth environment, and so on are easy stories to tell.

In this view, by the way, as the real rate recovers along with the economy, if the actual nominal interest rate is stuck at zero, then inflation should gently decline. That is also what we see.

Plus, after 8 years, if monetary policy were really "stimulating'' quite so much, where is the inflation and boom?

Heresy 2: Quantitative easing

As we have seen, in its quantitative easing (QE) the Fed bought nearly $3 Trillion of Treasurys and mortgage backed securities, giving banks interest-paying reserves in return.

• Conventional Wisdom: QE lowered long-term interest rate rates, and provided a big stimulus. QE's stimulative effect is permanent and continues to this day, so unwinding QE is vital to "normalizing'' policy.
• Heresy 2: QE did basically nothing to interest rates, or to stimulus.

The next graph is a plot of ten year rates and mortgage rates along with reserves. Again, the steep rises in reserves are the QE episodes.

Ten year treasury rate, 30 year mortgage rate, and reserves

Maybe the first QE is associated with a one percentage point drop in rates. But it bounces right back. Large transactions can move prices, but in the rest of finance we see these as temporary, not permanent movements. In the second and third QE, interest rates rise during the QE episode, exactly the wrong sign.

The bottom panel takes a longer view of interest rates Here you can see that interest rates have been on a steady downward trend since 1985. Can you see any difference in the behavior of these interest rates during the QE period from the late stages of the last three expansions? I can't.

Well, again, so much for the real world, how does it work in theory. As Ben Bernanke himself recognized, QE "works in practice'' or so he thought, but not in theory. We should worry about any proposition that has no theoretical basis. Sometimes facts are ahead of theory, but not often.

The Fed is in essence a huge money market fund. Banks sell bonds to the Fed, and get a money market account, backed by the Fed's holdings of the bonds. Just how much difference does it make for banks to hold treasurys through the Fed rather than directly?

We can think of them as open change operations. Reserves are government debt. So it's as if the Fed took a bunch of your $20 bills and gave you 2 $5s and a $10 in exchange. It's hard to see that having a big effect on your spending.

QE is catch 22. The usual story told is that bond markets are "segmented.'' The 10 year treasury market is cut off from other markets. Then, if the fed buys a lot of them it can raise the prices of 10 year treasurys. But the point of QE was not to lower Treasury rates, it was to lower rates that might influence investment. To affect the economy, the markets must not be segmented. For the Fed to affect the 10 year rates, they must be segmented, and the rates don't spill over to the rest of the economy.

Finally, the Treasury has been selling faster than the Fed has been buying. The next graph has all Federal debt, and federal debt less the part bought by the Fed. That bottom line is still growing. So, the Fed did not remove any bonds from the market. Overall, markets held more debt.

Federal Debt held by the public, and the same less debt held by the Fed.

Moreover, the Treasury was trying to move to a longer maturity structure. Treasury debt is much like your mortgage. If you take the 30 year fixed, you protect yourself against interest rate increases. If you take the floating rate ARM, you get a lower rates, but if rates go up you might be in a squeeze. The Treasury chose the fixed rate, trying to move to longer bonds. The Fed bought those long bonds right back up, issuing short term debt (reserves) instead, and undoing the insurance that the Treasury bought. Fed and Treasury need to get together and decide who is in charge of the maturity structure!

Heresy 3: Low rates, QE and financial markets

• Conventional Wisdom: QE and low interest rates set off a "reach for yield,'' "asset price bubbles,'' though artificially low risk premiums.
• Heresy 3: The risk premium is not unusually low for this stage of the business cycle. In any case, the Fed has nothing to do with risk premiums.

A quote from one of my otherwise favorite financial analysts expresses the view nicely:

"QE and negative interest rates manipulated prices of risk-free assets, and by artificially boosting risk-free assets central banks have sent investors on a hunt for yield, which in turn artificially boosted prices of risky assets and significantly distorted prices in financial markets.''

Again, this story gets passed on and on, but does it line up with the facts, and does it make any sense?

Risk premiums are about the spread between borrowing and lending. You take on risk by borrowing to invest. Now, if you borrow at 1 % and lend at 3%, that is exactly the same thing as borrowing at 3% and lending at 5%. Risk taking depends on the spread between risky and risk free rates, not the level of rates.

Yes, we can cook up stories, involving the affairs of specialized intermediaries. But recognize those are second-order stories, and hard to get risk premiums on widely traded stocks and bonds to go substantially wrong for years.

Let's look at the facts. Are there unusually low risk premiums or high asset prices, and are those tied to low interest rates or QE?

Spread between BAA and 10 year Treasury rate

This graph is the interest rate spread between Baa corporate bonds and 10 year Treasuries, a sign of the premium for holding the risk of corporate defaults. The premium is low now. But we are in the late September of the business cycle, and the corporate spread was even lower in each of the last three business cycles.

Risk premiums are always low in late stages of the business cycle. Risk is low, people are doing well, and willing to take risks despite low premiums. In fact, corporate premiums are still if anything surprisingly high for this stage of the business cycle, a fact often attributed to bank's unwillingness to trade much under the more stringent capital standards.

The next graph presents Bob Shiller's long-run price/earnings ratio. The price/earnings ratio is high. But it's also always high at the late stage of expansions, as people are more willing to take stock market risk in good times.

Price-earnings ratio on S&P500. Source: Robert Shiller

Moreover, looking at this century of data, the current time period with zero rates and massive QE does not stand out as particularly different from events we have seen many times before.

(Not: ignore the interest rate in the chart. It is the nominal interest rate, which reflects inflation, and is not relevant to the question here. I just copied Shiller's chart so didn't remove the line.)

Even so, it still seems high, but the price earnings ratio reflects the level of interest rates as well as the spread. The classic Gordon growth formula states that the price / earnings ratio equals one divided by the stock's rate of return minus the growth rate of dividends. We can also break down the stock rate of return into a real risk free rate and a risk premium. \[ \frac{P}{E} = \frac{1}{E(r)-g} = \frac{1}{r^f + E(r-r^f)-g} \] Now, suppose the real risk free rate goes down by one percentage point, leaving the risk premium alone. If the price/earnings ratio starts at 25, or expected returns four percentage points above growth, \[ \frac{P}{E} = 25 = \frac{1}{0.04} \] a 1% decline in real rate gives \[ \frac{P}{E} = 33 = \frac{1}{0.03} \] with no change in risk premium. That's just about the amount by which the price/earnings ratio is unusually high

Heresy 4: Real rates

All of my heresies revolve around the question of low interest rates, and you might object that yes, interest rates are low, but that's because you think the Fed is keeping interest rates low.

• Conventional Wisdom: The Fed is the primary force behind movements in the real rate of interest and GDP growth rates.
• Heresy 4: The Fed has little to do with real interest rates or economic growth rates (past $\approx$ 1 year).

This is just economics 101. The two most basic economic descriptions of interest rates are \[ \text{real rate} = \text{impatience} + (\approx 1-2) \text{growth rate} \] \[ \text{real rate} = \text{marginal product of capital} \] If people are impatient, you have to pay them higher interest rates to get them to save. If the economy is growing quickly, and people know they will be better off in the future, you have to pay them higher interest rates to get them not to consume today. And the interest rate is determined in the end by companies' ability to make real returns from borrowed money.

As we go in to an economic expansion, with higher growth, real interest rates will naturally rise, Fed or no Fed. As we go into a period of low or no growth and poor investment opportunities, real interest rates will be low, Fed or no Fed.

And after a few years, growth comes from productivity only, not anything the Fed can arrange.

Now, there are many stories told for low growth and low "natural '' real rates -- a "savings glut,'' a demographic bulge of middle age savers, low investment productivity from distorting taxes and regulation, and so on.

Moreover, real rates are low everywhere in the world. It isn't specific to the Fed.

In sum, the Fed is nowhere near as powerful as conventional wisdom suggests.

Heresy 5: Is the economy stable?

• Conventional wisdom: If interest rates are stuck or pegged, inflation or deflation will spiral out of control. The economy, on its own, is unstable. The Fed must constantly move interest rates, like the seal must move his nose, to keep inflation under control.
• Heresy 5: The economy is stable. If interest rates don't move, eventually inflation will adjust to that interest rate minus the natural real rate of interest.

Conventional wisdom makes a clear prediction. When the interest rate gets stuck at zero, deflation will spiral out of control. The next graph gives a simulation of a standard (adaptive expectations, ISLM) model. A deflationary shock hits, and inflation declines. The Fed lowers interest rates, but soon runs in to zero. When the interest rate hits zero, the deflation spiral breaks out.

The model in this figure is: \begin{align*} x_t &= -\sigma (i_t - \pi_{t-1} - v^r_t)\\ \pi_t &= \pi_{t-1} + \kappa x_t; \\ i_t &= \max[i^\ast + \phi (\pi_t -\pi^\ast),0] \end{align*}

Simulation of an old-Keynesian deflation spiral at the zero bound.

The facts deny this central clear prediction. Remember the lesson of the first graph, on what happened when interest rates hit zero and stayed there. There was no spiral.

Modern theory and fact agree: Inflation and economy are stable with fixed rates.

That does not mean that fixed interest rates are a good thing. They are possible, but not necessarily desirable. Remember \[ \text{interest rate} = \text{real rate} + \text{expected inflation} \] If interest rates are fixed, then as real rates vary -- remember, real rates should be low in recessions and high in booms -- inflation must vary, and in the opposite direction. Prices are a bit sticky and volatile inflation is not desirable. So even in the view that inflation is stable with fixed interest rates, it is still a good idea for the Fed to raise rates in boom times and lower them in recessions. The Taylor rule is alive and well. But the zero bound or slightly slow to move rates are not a spiral-tempting disaster.

Heresy 6: How does this thing work anyway?

• Conventional wisdom: Raising interest rates lowers inflation, & vice-versa.
• Heresy 6 (Implication of stability & modern theory). After a short run negative effect, persistently higher interest rates raise inflation.
• Are we past bump, at the point that persistently low rates have led to low inflation?

If inflation is stable around fixed interest rates, then if you raise rates and leave them there, inflation must eventually rise to meet the interest rates.

It's not as nutty as it seems. Most of our experience is the short run relationship, which is negative.

However, this possibility -- this consequence of stability -- suggests that after 8 years near zero, we have gotten over any negative response of inflation to rates, and low interest rates are attracting low inflation. And that if the Fed raises rates, it will eventually cause the inflation that it will, in the event, pride itself for foreseeing.

Consistent with this view, consider Japan and Europe in the next plot. Both of them have lower -- negative -- interest rates than we do. And inflation is drifting down in both places. Which is the chicken, and which is the egg?



Heresy 7: The Phillips curve

Conventional wisdom, largely reflected in Federal Reserve statements, has a clear view of where inflation comes from.

• Inflation comes from "tight markets,'' principally tight labor markets.

As I write, conventional wisdom says that the low unemployment rate, and other measures such as many unfilled job openings presage wage inflation, which will be passed through to price inflation. This view motivates the hawkish case for raising interest rates, even though current inflation remains below the Fed's 2% target, and accounts for the fact that the Fed has raised rates at all.

The conventional view of monetary policy acts through this causal channel. Lower interest rates will stimulate aggregate demand, which will stimulate output, which will cause companies to hire more people, which will tighten labor markets, which will lead to higher wages, which will lead to higher prices.

Sometimes, the correlation between inflation and unemployment is read the other way. (We economists seem to specialize in reading correlations as causal relationships, and forgetting that there are two curves that may shift in any set of observations.) In the recession, if only the Fed could raise inflation, the story went, it could thereby reduce unemployment. Bring on the helicopters full of money.

In any case, even the Phillips curve correlation has vanished, if it ever was there.

Core inflation and unemployment. Top: time series. Bottom: Inflation (y) vs. unemployment (x) since 2007

The top panel of this graph shows the time series of inflation and unemployment through the last two recessions. You can see inflation blip down and unemployment rise in the bottom of a recession. Even that correlation vanishes though in the subsequent expansion and most of all in the last one. Inflation quickly bounces back to a bit below 2%, while unemployment remains high. There is just no relation all between the level of labor market "slack'' and the rate of inflation.

The bottom panel shows the data since 2008 as a scatterplot, with inflation on the left and unemployment on the bottom. Your eye may wish to draw a negatively sloped line. But really the evidence there is on the right hand side -- inflation dipped down and came back up while unemployment stayed high. The traditional scatterplot is a bit misleading because the points are not randomly chosen, but follow each other as you can see in the first plot.

The plot really shows that there is essentially no relationship between inflation and unemployment -- the line is flat. Furthermore, there is a lot of vertical scatter -- the line isn't really a line.

(A clever Fed economist once parried, yes, the line is nearly flat! That's great news. It means if we could only get inflation up half a percent we would instantly cure unemployment. The vertical scatter emphasizes that the line is really just mush, not an exploitable flat line.)

Well, once again, so much for the real world, how does it work in theory? Nothing seems more obvious than the proposition that if labor markets are tight, if there are more jobs than people who want to work, that employers will offer higher wages, right?

No, as a matter of fact. If employers want to attract more workers, they must offer higher wages relative to prices. Saying "I'll pay you in pennies'' doesn't do any good. Both prices and wages rising at the same time does nothing to attract workers. If wages are "sticky'' then the only way to have wages rise is for product prices to fall -- we should expect tight labor markets to result in less inflation in goods prices!

Likewise, perhaps inflation comes from tight product markets, and what could be more natural than the idea that if there is more demand than supply that companies should raise prices. But that also only works for relative prices.

This is one of the first, most important, and most forgotten lessons of macroeconomics. What works for an individual market does not work for the economy as a whole. The overall price level is a different object than (relative) prices or wages. (And, similarly, trying to raise everyone's income by raising everyone's relative income, handing out protections to each industry and to labor, is equally doomed. No, we cannot pull ourselves up by our bootstraps.)

Now (of course) there are economic theories of the Phillips curve, and good ones. To get the overall level of prices and wages to correlate with labor or product market slack, you need some second-order effect, some "friction.'' The easiest one to understand is Bob Lucas' classic theory. In this context, employers can fool people into working harder for a little while by posting higher wages. If the people don't know that prices are going up too, they will think the real wage (relative to price) is higher, and not realize they are just being paid in devalued currency. Once they figure it out, of course, the boost to employment vanishes. (Also, this is a theory of causality from unexpected inflation to higher employment, not the other way around.)

The point here is not that there is no theory of the (apparently vanished) Phillips cure. The point here is that the simple commonsense idea that tight markets cause inflation is wrong. If you want a theory, you need to go past obvious supply and demand and add some friction to pricing or to information processing, and then you need to think the Fed understands and can exploit this friction to guide us to better outcomes than we get to on our own.

Maybe that's not how the economy is wired. Maybe labor market "tightness'' and "slack'' is not the root of inflation.

Heresy 8: Inflation Dangers

Source: CBO

• Conventional Wisdom: The danger of inflation comes if the Fed does not raise rates quickly enough. Then we have a positive spiral.
• Heresy 8: The inflation danger comes from fiscal policy. A Greek unwind. As past low-rates and pegs evaporated due to fiscal problems. And then Fed will be powerless to stop it.

If inflation is indeed stable, then small mistakes in monetary policy will not lead to spiraling inflation.

Inflation, like all crises, usually comes from unexpected sources. Our fiscal situation leads to a chance of inflation. If interest rates rise to 5%, our government will have to pay $ 1 trillion per year of additional debt service. It can't. This event could pile on top of a new financial crisis and recession occasioning a few more trillion dollars of borrowing, on top of unreformed taxes and entitlement spending. People seeing that crisis coming will unload government debt, try to buy real things, and drive inflation. If that happens, there is nothing the Fed can do about it.

This possibility is not a forecast. It's a risk, and a small risk, like living above an earthquake fault that breaks every few hundred years. That doesn't mean you should rush out of the house right now. But that doesn't mean we're safe either. Bond markets still trust the US to sort out our fiscal mess. But if they ever lose that faith, we get inflation -- stagflation -- that will seem to the Fed, and to conventional wisdom, to have come from nowhere.

Kevin Volpp, University of Pennsylvania, is the Janet and John Haas President’s Distinguished Professor of Medicine and Medical Ethics and Policy at the Perelman School of Medicine and Health Care Management at the Wharton School. He is also the founding Director of the Center for Health Incentives and Behavioral Economics (CHIBE), Vice Chairman for Health Policy for the Department of Medical Ethics and Policy, and Director (with Karen Glanz) of the Penn CDC Prevention Research Center.

Dr. Volpp’s work focuses on developing and testing innovative ways of applying insights from behavioral economics in improving patient health behavior and affecting provider performance. He has done work with a variety of employers, insurers, health systems, and consumer companies in testing the effectiveness of different behavioral economic strategies in addressing tobacco dependence, obesity, and medication non-adherence. He has competitively been awarded more than $60 million to lead or co-lead studies funded by the NIH; the Center for Medicare and Medicaid Innovation; the CDC; VA Health Services Research and Development; Robert Wood Johnson Foundation; the Hewlett Foundation; the Commonwealth Foundation; the Aetna Foundation; Mckinsey; CVS Caremark; Horizon Blue Cross Blue Shield; Hawaii Medical Services Association; Merck; Humana; Aramark; Weight Watchers; and Discovery (South Africa).

His work earned him the 2015 Matilda White Riley Award, issued by the National Institutes of Health Office of Behavioral and Social Sciences Research (OBSSR). The Matilda White Riley Award is given in recognition of an outstanding behavioral or social scientist whose research has contributed to both the deepening of knowledge and its application in a manner that furthers NIH’s mission of improving health.

See https://hcmg.wharton.upenn.edu/profile/volpp70/ or https://chibe.upenn.edu/ for more details about Kevin’s work. An excellent overview of his work including an interview with Kevin is available at https://obssr.od.nih.gov/kevin-volpps-alchemy-turning-principles-of-behavioral-economics-into-healthier-people/

Professor Volpp is visiting Galway to speak at the MedTech Rising conference that will take place at the Radisson Hotel on December 6 and 7. See http://www.medtechrising.ie/#Agenda for more details.

Applications are invited for positions as Lecturer\Assistant Professor in the UCD School of Economics. Applicants must have an active research track record and be an effective communicator capable of excellence in teaching at undergraduate and postgraduate levels. Applications from all fields of Economics are welcomed though priority for one of the positions will be given to applicants with expertise in macroeconomics, financial economics or econometrics.

Note: Representatives of the School of Economics will be available to meet with potential candidates at the ASSA Meetings in Philadelphia over January 5-7, 2018 and at the RES PhD Meetings in London over 19-20 December, 2017. Please contact Professor Karl Whelan, Head of the School of Economics (karl.whelan@ucd.ie) for further information.

95 Lecturer/Assistant Professor above the bar Salary Scale: €51,807 - €79,194 per annum

To illustrate MV = PY. (It was MV=PT then.)  In  Irving Fisher, "The Equation of Exchange 1896-1910," The American Economic Review Vol. 1, No. 2 (June, 1911), pp. 296-305, via JSTOR.

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

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

The post starts with the story of a family that

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

Alas,

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

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

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

The conundrum

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

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

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

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

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

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

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

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

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

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


Our author has learned an important lesson.

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

The pattern instead, and the bottom line:

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

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

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

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

O'Toole:

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

Just in time for self-driving Ubers to arrive.

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

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

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

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

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

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

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

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

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

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

Source: Obtainium works.

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

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

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

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